DAO Raise — A Comprehensive Legal Guide for Structuring a DAO Token Sale: Best Practices

This article was first released in Forklog (Russian language).

Understanding DAO Raises

In essence, a DAO is a type of organization that leverages blockchain technology to operate without a central authority, giving its members decision-making power. This is often facilitated through a system of tokens, which represent the right to participate in the governance of the project and vote on DAO resolutions.

DAO token sales, also known as DAO offerings or DAO raises, are fundraising efforts wherein the DAO directly sells its tokens to raise capital. DAO raises serve as fundraising tools to finance the DAO’s expenses, development, hiring, and marketing efforts.

In a DAO raise, unlike conventional offerings, the purchasers transfer funds to a multi-signature wallet controlled by the DAO and receive tokens also directly from the decentralized organization. The distribution of tokens in such sales is typically executed via a distribution smart contract implemented by the DAO upon closing the sale.

Legal Terrain: Challenges and Considerations

In this discussion, we will be focusing on DAOs that have not established a legal or corporate structure, as these entities tend to confront the most substantial challenges in legal matters. It’s important to note, however, that for decentralized organizations that have some sort of legal structure in place, conventional fundraising schemes are likely to be the best choice for structuring their fundraising efforts.

DAOs typically confront a myriad of legal hurdles during a DAO raise, including potential unlimited liability, absence of legal protection, tax implications, and difficulties performing due diligence or KYC (Know Your Customer) processes.

Unlimited Liability

A DAO without a defined legal structure can be deemed a general partnership or association across many jurisdictions worldwide. In such a partnership, every member can be held jointly and individually accountable for the organization’s debts. Consequently, as a DAO member, you could potentially face personal liability for all DAO liabilities with no limitations. For instance, a California federal court recently decided in the bZx DAO case that bZx DAO should be treated as a general partnership, with all members holding bZx tokens considered partners.

Lack of Legal Protections

Compounding the issue of unlimited liability is the lack of legal protection for DAOs in the absence of formal agreements or other protective measures. Typically, extensive legal documentation is prepared during a token sale to limit potential liability, clarify responsibilities, and address compliance and regulatory issues.

However, in a DAO raise, the lack of formal contracts leaves these matters unregulated, presenting considerable risks for the DAO and stakeholders involved in the transaction and its performance.

Tax Considerations

In the absence of a distinct entity performing the role of token offeror or seller, accurately interpreting and treating the proceeds from the token sale, as well as funds received by the DAO, is of paramount importance.

Depending on the jurisdiction of the DAO’s key actors and stakeholders involved in the transaction, diverse tax laws could lead to unfavourable tax implications, for instance, the proceeds might be considered as taxable income.

Jurisdictional Complexities

A typical DAO raise isn’t restricted by the jurisdictions where the tokens are being offered or sold. This is important because many countries have their own legal frameworks, which could heavily regulate or even outright ban token offerings. In certain jurisdictions, even without explicit regulations, public token sales could potentially be seen as violating existing securities or financial laws. Lastly, there are countries subject to sanctions, and you wouldn’t want to be caught violating applicable sanction regimes.

To shield the project from potential legal risks associated with token offerings, the project needs to develop a list of restricted jurisdictions whose residents it won’t accept as token buyers. But how can a project truly enforce this restriction on token sales? The answer is due diligence or KYC.

Challenges in Conducting Due Diligence / KYC

The KYC procedures have already become an integral part of modern token offerings. This process verifies a person’s details, ensuring they are real, not subject to sanctions, and not residing in a prohibited jurisdiction. If the KYC is complemented with a KYT (know-your-transaction) verification, the project can further confirm that the funds used by the buyer to purchase the tokens are not from illicit sources.

In a DAO raise, performing due diligence or KYC can be challenging as purchasers usually prefer to keep their identities confidential and avoid any public disclosure. No one would agree to publish their personal data to enable the DAO to review it. Additionally, it is unclear how and who should conduct the due diligence.

A small spoiler — there is a way out, read below.

Structuring a DAO Raise: An Elaborate Guide

First of all, it’s important to distinguish between DAOs with established legal structures, and those without — which we refer to as “unincorporated DAOs”.

In this section, I’ll discuss tools and mechanisms that an unincorporated DAO can leverage to structure its DAO raise in a way that provides some level of legal and financial protection for its members and contributors. On the other hand, for DAOs with existing structures, traditional instruments used in conventional offerings would typically suffice.

Governance Resolution

Every DAO operates with its own governance procedures that must be adhered to when conducting a DAO raise. Moreover, it’s common for the tokens sold to originate from the treasury, hence necessitating a DAO resolution for their utilization. Ideally, this resolution should clarify the following aspects:

• Sale Parameters: This includes the total number of tokens to be sold, the price per token, and the type of accepted consideration (for instance, whether purchases can be made using USDC, ETH, or other digital currencies, and on which networks);
• Token Restrictions: Clearly defined lock-up and vesting terms applicable to the tokens sold should be outlined to ensure all participants understand the constraints;
• Application Procedure: minimal check (purchase amount), application process, KYC requirements, etc.
• Transaction Mechanics: The purchaser’s actions following application approval, for example, the requirement to provide specific information and pass screenings, payment rules, and details of the wallet to which the payment must be made;
• Key Deadlines: Important deadlines, such as the deadline for applications, provision of required information, passing KYC, sending the payment, etc.

Due Diligence / KYC

Executing KYC procedures and ensuring compliance during a DAO raise can present a complex task, particularly given the general hesitance of DAO token sale participants to share their personal information.

One of the options that the DAO could employ to circumvent this obstacle would be to engage a law firm to conduct the necessary checks on the DAO’s behalf. For instance, at AURUM, we have successfully facilitated KYC/KYT checks on potential participants in several DAO raises. Here’s a simplified overview of our procedure:

• We initiate contact with the DAO and make an offer, typically via a forum post or discord message, offering our services;
• The DAO, in response, passes a resolution to engage us for conducting the KYC checks, and provides a list of potential purchasers for verification;
• We engage with each prospective purchaser, collect required information and documents, and conduct the checks, including to verify the eligibility of each purchaser;
• Upon completing these checks, we produce a report listing the wallet addresses that have passed the due diligence process and their corresponding purchase amounts;
• Armed with this report, the DAO securely completes the raise, offering their tokens exclusively to purchasers who have been verified.

In this framework, purchasers are required to share their personal information solely with the law firm engaged by the DAO, hence their personal information is not disclosed to anyone else, including the DAO or the public. The final report issued by the law firm should not include any sensitive data as well.

This methodology enables the DAO to only admit purchasers who have been duly verified and meet their specific eligibility criteria. Concurrently, it provides an avenue for purchasers to partake in the DAO raise without the need to divulge personal information to the DAO or any unidentified persons. This balance ensures a level of security and privacy for all parties involved in the transaction.

Token Sale Instrument

While I recognize the philosophy of “code is law” and its influence on the blockchain world, it’s important to remember that code alone cannot address all the legal intricacies and implications inherent in the DAO raise transactions, at least yet. Not to mention that for some of the purchasers, the absence of a contract could present a deal breaker.

That is why when structuring a token sale, my recommendation is to employ a token sale instrument to frame the transaction and formalize the key legal terms. Because DAOs don’t have a traditional business structure, we usually use something called “one-sided letter agreements” to manage these sales, but another option would be to use the token sale terms and conditions as the token sale instrument.

Even though these agreements are signed exclusively by the purchasers, a proper legal design allows for an extension of their applicability to third parties involved in the project or the DAO raise. Through the application of appropriate legal language, the most exposed stakeholders, such as multi-sig controllers and promoters, will be granted the ability to rely on the terms of the token sale instrument and its limitations of liability as if they were signatories themselves.

This strategy infuses an element of certainty into the transaction, offers a measure of legal protection for the DAO and key stakeholders involved in the raise, and further maintains the spirit of the decentralized ethos.

Executing the DAO Raise

Following the successful completion of the KYC/KYT checks and after the token sale agreements have been signed by all eligible purchasers, the latter can transfer the funds to the DAO multisig wallet designated in the relevant resolution.

The DAO would then progress to the next step which involves deploying the distribution smart-contract which allows buyers to claim and collect their tokens in accordance with the vesting schedule established for the transaction.

Taxation

The acquisition of funds from the sale of tokens during a DAO raise can potentially trigger intricate tax implications. This is particularly relevant for individuals involved with multi-signature wallets or tasked with managing funds on behalf of the DAO.

Unless a special purpose vehicle (SPV) is used to structure the DAO raise, there are limited options for managing the associated tax liabilities efficiently. For those considering an SPV, I would suggest implementing a purpose trust, which is one of the most efficient and easy-to-form options available. Such a purpose trust can be used to wrap the multi-signature wallet that is used in the DAO raise. You may read more about the Guernsey purpose trust model in this dYdX article.

In other cases, I would recommend seeking professional tax advice to understand potential obligations and explore strategies for effective tax planning. All parties involved should be fully aware of their individual and collective tax liabilities to ensure compliance with local and international tax laws.

End Result: The Reinvented DAO Raise

As we reach the final steps of a DAO raise, the outlined structure begins to demonstrate its full potential, offering a harmonious blend of decentralization, compliance, and legal protection. But what does this mean in practice for DAO members, purchasers, and stakeholders? Let’s break it down.

• For DAO members, the structure offers a level of legal protection and financial security. It keeps the decentralized ethos intact while introducing procedures for compliance and risk mitigation. The fear of potential legal implications gets significantly reduced.

• For the purchasers, the KYC checks handled by a professional service provider offer privacy and a sense of security. They are assured that their personal information is handled professionally and confidentially. Moreover, the clear and well-structured purchase procedure helps them know exactly what they are getting into.

• For key stakeholders, like multi-sig controllers and promoters of the token sale, this structure provides the ability to rely on the terms of the agreement and its limitations of liability, thereby minimizing their potential legal exposure.

In Conclusion

In conclusion, while a DAO raise brings with it a unique set of complexities, employing the right mechanisms and tools can transform it into a manageable process. By following the guidelines outlined in this article, DAOs can approach their fundraising with a comprehensive and reliable structure, all the while preserving the fundamental principles of decentralization and participation that are the very essence of DAOs.

With these practices in place, we move one step closer to a future where DAO raises are not just possible, but also efficient, secure, and legally compliant.