The Complete Guide To Governance Tokens

The Complete Guide To Governance Tokens

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minute read time
Bryan Wilson
Bryan Wilson
Legal Engineer
Bryan Wilson
Published:
September 15, 2022
Last Updated:
October 27, 2022

This is part four in our four part series on the Taxonomy of Tokens. You can see the previous articles on Security/Utility Tokens here, our deep dive on Liquidity Provider Tokens, and our complete guide to NFT's.

Governance tokens are digital assets that give the owners of the assets the right to vote on specific projects.

What Are Governance Tokens?

Governance tokens are digital assets that give the owners of the assets the right to vote on specific projects, usually associated with a DAO.

By combining financial or community interests with programmable representations for decision-making, crypto innovators have found a way to use Governance Tokens to reduce the gaps between organizational set-up, implementation, and execution.

Uniquely, compared with other types of tokens, Governance Tokens may actually take many forms. There are security tokens, utility tokens, and Liquidity Provider staking tokens, that each perform a governance function. In this article, we will provide an overview of Governance Tokens by looking at the historical context of Governance Tokens and exploring the different ways they can be used to compose organizations, including DAOs.

Background

History has shown that the development of new technologies for rulemaking and governance enables new business models. From the Code of Hammurabi and stone contracts, to market monies and grain receipts, to the creation of land registries, to the advent of blockchain and smart contracts, each of these innovations makes it possible to identify parties in a transaction, set permissions based on different events, and execute the transfer of value based on rules that are predetermined and agreed upon by a group.

The creation of Governance Tokens has facilitated the rise of Decentralized Autonomous Organizations (DAOs), Cybernetic Organizations (cybOrgs), and other digitally enabled business models represents the next evolution in the ways that people can organize themselves, work on tasks, raise funds, or build communities. However, defining the attributes of these newfangled forms of governance has proven particularly tricky. The reason this matters is because the different architectures – or code – that are used for representing an organization require different safeguards to protect it.

Think about it this way: if you want to make rules that prevent a combustion engine from malfunctioning, the rules necessarily depend on what type of an engine you have – a combustion engine for a train will require different sets of rules than a combustion engine for a car, for example. A more relevant example, when thinking about the incorporation of a digital technology to a legacy business model, appears with ridesharing apps such as Uber and Lyft and the Taxi industry. The digital platforms are able to do things that the incumbent industry is unable to do, including automatically accepting payment, rating the behavior of drivers, and easily providing comprehensive records of transactions to users. However, there are also new risks associated with these new technologies. Uber and Lyft, for example, enable the algorithmic discrimination of certain areas and groups based on rase, increased congestion, and reduced vetting and identity theft in registration processes for drivers.

And while governance tokens of the Web3 variety have not been around for very long, the sentiment motivating their precipitation has existed for a long while.

Looking through the anthropological and biological literature, it becomes clear that the history of DAOs is actually one of analogies – creating parallel paths between different types of systems that function in similar patterns. In 1962, W. Ross Ashby, one of the fathers of cybernetics, published Principles of the Self-Organizing System, wherein Ashby provides a thorough overview of the components comprising a self-organizing system (of which DAOs are arguably a type of self-organizing system).

Then, in 1968, at the Association for Computing Machinery / Institute of Electrical and Electronics Engineers (ACM/IEEE)—Computer Society's Fall Joint Computer Conference in San Francisco, Doug Englebart gave a live demonstration, the Mother of All Demos, which showcased of windows, hypertext, graphics, navigation, command input, word processing, file linking, and collaborative editing. This potential of computers, he believed, could facilitate the creation of an organizational efficiency or collective IQ that would enable people to coordinate and participate on projects in new and exciting ways together.

Fast forward to 1990, and Steve Jobs took this further when he hypothesized about interpersonal computing could lead directly to the creation of flat organizations that are digitally enabled, exist for a specific purpose, and then dissolve once their purpose is achieved. Now, we are getting to a critical moment in 2008, where these cybernetic systems are becoming more mainstream and increasingly embedded in commerce. At this point in time, people are using smartphones, and internet connected devices are becoming both more powerful and more widely used. But the reason 2008 is so important to the timeline of composable digital organizations is because it is the year Bitcoin was created. Bitcoin was created by Satoshi Nakamoto as a network that rewards people who maintain the network with mining rewards.

"To some, the Bitcoin (BTC) network is the earliest example of a DAO there is. The network scales via community agreement, even though most network participants have never met each other. It also does not have an organized governance mechanism, and instead, miners and nodes have to signal support. However, Bitcoin is not seen as a DAO by today’s standards. By current measures, Dash would be the first true DAO, as the project has a governance mechanism that allows stakeholders to vote on the use of its treasury."
- CoinTelegraph, "What is a decentralized autonomous organization, and how does a DAO work?"

Drawing from the self-organizing nature of the network, the autonomy of its execution, and the miners, developers, and others who participate with the network, Bitcoin is arguably viewed as the creation of the first DAO. While the criteria for what comprises a DAO remains to be settled, Bitcoin is a distributed network. Bitcoin functions autonomously, per the instructions transcribed in the code. And Bitcoin is organized in a way that facilitates the governance of the network.

This is all to say that each container that is used to represent the various functions of an organization, such as membership, roles, permissions, decision-making, etc. has different strengths and weaknesses. DAOs and their ilk are no exception to this rule.

Exploring the Potential for Governance Tokens

When analyzing the potential for governance tokens, it is helpful to break that potential down into individual components. To start with, there is a direct impact Governance Tokens can have for the integration of legal rules into technical architectures. Additionally, it becomes easier to capture more sophisticated means of decision-making through tokenized architectures. Then, Governance Tokens can also be used to dynamically enforce or adapt to specific types of behaviors.

Legal Integration

One of the biggest areas for opportunity with governance tokens is legal integration – the extent to which legal rules for governance might be embedded into a technical architecture. Some governance tokens will choose not to address this, in which case they would not be legally integrated. Other governance tokens will choose to directly address this, in which case they will be fully integrated. And still, there will be those who choose to address this to some partial extent, in which case they will be partially integrated. For purposes of this document, legal integration can take place in two ways: 1) governance tokens can be used to create a legal wrapper for an organization, such as a DAO, or 2) governance tokens can be used to create binding legal obligations through their use.

At its most basic level, a legal wrapper creates legal personhood for an organization. In the context of governance tokens, tokenization of a legal wrapper necessarily implies some type of DAO, cybOrg, or other web3-native organization. The range and variety of these organizations is bigger than just DAOs, although DAOs are the most popular. Among the reasons an organization would choose to adopt a legal wrapper instantiated by a governance token include the ability to easily engage with service providers like bankers, lawyers and consultants, as well as be able to pay taxes. A legal wrapper will be jurisdiction specific and can include B-corps, C-corps, LLCs, or other legal entities in the United States. Abroad, legal wrappers can include additional arrangements. A legal wrapper may be fully integrated (i.e., the authoritative bylaws of the organization as listed in the corporate filings link to code) or partially integrated (i.e., some component of the organization is referenced in corporate filings). 

For a more in depth overview of Legal Wrappers and DAOs, I recommend checking out the below DAO Entity Matrix from Paradigm and the article Legal Wrappers and DAOs by Chris Brummer and Rodrigo Seira.

An overview of legal wrappers and DAOs, courtesy of DAO Entity Matrix from Paradigm

Decision-making

Another big innovation that governance tokens enable is the ability to program increasing sophisticated decision-making mechanisms in an organization. Decision-making, in this context of governance, is analogous to corporate governance; corporate governance focuses on the question of how to motivate corporate board members to act in the interests of their stakeholders and formulates contractual and regulatory solutions. As tokenization enables new types of rules to be encoded into an organization's DNA, groups are able to determine the types of decision-making mechanisms that are most suited to their needs and literally embed them within the organization. Governance tokens innovate upon traditional voting mechanisms by enriching the process for voting, as well as by making it more efficient.

The use of governance tokens by an organization makes voting more efficient. In the same way that Bitcoin served as a direct response to the financial crisis of 2018, governance tokens can be seen as a direct response to the current state of corporate governance. Traditionally, corporate governance has eroded into a dull ritual with procedural flaws that takes longer than it should and that is susceptible to fraud. Governance Tokens are by no means a panacea, by any means, but it does allow us to program interfaces for voting with the speed and trust of blockchain.

Perhaps what is most exciting about governance tokens is that they turn the concept of governance into a blank canvas that can be encoded to achieve certain types of outcomes. By coordinating what would otherwise be impractical, governance tokens simplify operations that would otherwise take lots of time and be susceptible to fraud. For example, a governance token could facilitate lots of different types of voting, including executive voting (continuous evaluation of proposals), quadratic voting (enabling the community to purchase more votes for certain issues), ranked choice voting (proportional representation), holographic consensus (approval by a small, representative group within a large organization). Governance tokens also enable organizations to choose among several different methods to allocate votes, such as the company model (one vote per share), the membership model (one vote per person), or the reputation model (hybrid of the company model and membership model), executive voting. Governance tokens even enable organizations to add incentives like staking can be added to voting to increase or limit participation in the best interests of the organizations. Governance tokens can be used to facilitate voting onchain or offchain using something like Snapshot.

Behavior :: Coordination v. Investment v. Hybrid

The byproduct of legally and technically integrated organizations that are able to compose and make more efficient their decision-making processes is a newfound ability to design an organization to achieve certain behaviors. This was the big realization of Vitalik Buterin's 2014 piece DAOs, DACs, DAs and More: An Incomplete Terminology Guide.

Vitalik Buterin, DAOs, DACs, DAs and More: An Incomplete Terminology Guide (2014)

As web3 communities continue to experiment with governance tokens, certain trends and applications have emerged as stronger design patterns than others. What does this mean? This means that governance tokens are beginning to see some standardization within three predominant flavors: governance tokens for the coordination of behavior, governance tokens for the financing of some investment, and hybrid governance tokens to coordinate behavior that is closely aligned with an investment. Effectively, these are the atomic structures of individual organizations. However, it is important to remember that, in the same way different atoms can combine to form molecules, different governance tokens can be combined to form bigger, nested governance structures.

Generally speaking, Coordination DAOs serve to coordinate activity for a group of people without expecting returns. When a group of people seek to collectively perform a complex task, they require a coordination mechanism. Many strong examples of Coordination DAOs exist in the gaming space. Making games requires a high level of coordination and alignment across large groups of people. At a basic level, this makes sense because the practice of developing a game traditionally requires a heavy emphasis on user research and experience design, which heavily rely on the coordination of people who most care about a game – the gamers. By using governance tokens to coordinate the functions of a game's development a DAO can help ensure the products it is building are suited for the market it desires. Because these DAOs are not dealing with securities, it is typically common for these organization to have less formal governance structures.

Investment DAOs are community governed groups that allow capital pooling and invest in projects with the goal of producing returns. As they deal with the investment of money in a common enterprise with expectation of profits that relies on the work of others, the governance tokens used to deploy and Investment DAOs are typically going to be security tokens, as well. Because these types of DAOs are dealing with securities, they will typically be formed in a way that gives them a shield of liability. This means Investment DAOs will usually see a more robust governance structure in place to account for these needs. The LAO is a great example of a project that allows members to pool capital, invest in projects, and share in any proceeds from the investment. The LAO is organized as a Delaware LLC, primarily administered via an online application and associated smart contracts.

Hybrid DAOs function with some combination of the above DAO tooling (e.g., a mechanism for coordinating and a mechanism for investing). These mechanisms could be blended into one organization that meets the heightened requirements of the SEC or the mechanisms could be stratified into two organizations that closely collaborate together. Hybrid DAOs can help minimize inefficiencies and reduce wasted energy while enabling companies to establish exactly which aspects of their governance should be decentralized and to what extent this should happen. A great example of a Hybrid DAO is LinksDAO, a DAO attempting to purchase and provide access to golf courses all over the world. Members purchase NFTs to represent the type of membership that they have. The NFTs enable the member to vote on specific governance proposals and receive access to specific services and opportunities.

The organization is keeping all the money from the NFT sale on a platform called Gnosis Safe with a multi-sig. This means that the digital safe requires signatures from multiple people to move any funds. LinksDAO uses a separate operating entity called LinksDAO Inc. to manage the ownership of any physical assets, as well as serve as the day-to-day operating company for the prospective golf course. Pending legal nuances, LinksDAO also plans to give its DAO members the first opportunity to purchase into the operating company. If realized, some NFT purchasers could ostensibly receive equity ownership of a physical golf course and receive cash flows from the operation.

This article does not constitute investment and/or legal advice, and is strictly for education purposes only. Upside is not an SEC registered investment advisor, practicing legal entity or any other type of licensed body that can legally provide investment and legal advice. Upside is not responsible for any errors or omissions in this article, due to the changing nature of laws, rules and regulations or otherwise, or for results obtained from use of the information it contains.

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