” What is a decentralized autonomous organization, and how does a DAO work?” Part 2

Why do we need DAOs?

Being internet-native organizations, DAOs have several advantages over traditional organizations. One significant advantage of DAOs is the lack of trust needed between two parties. While a traditional organization requires a lot of trust in the people behind it- especially on behalf of investors – with DAO only the code needs to be trusted.

Trusting that code is easier to do as it’s publicly available and can be extensively tested before launch. Every action a DAO takes after being launched has to be approved by the community and is completely transparent and verifiable.

Such an organization has no hierarchical structure. Yet, it can still accomplish tasks and grow while being controlled by stakeholders vis its native token. The lack of hierarchy means any stakeholder can put forward an innovative idea that the entire group will consider and improve upon. Internal disputes are often easily solved through the voting system, in line with the pre-written rules in the smart contract.

By allowing investors to pool funds, DAOs also give them a chance to invest in early-stage startups and decentralized projects while sharing the risk or any profits that may come out of them.

The principal-agent dilemma.

The main advantage of DAOs is that they offer a solution to the principal-agent dilemma. This dilemma is a conflict in priorities between a person or group (the principal) and those making decisions and acting on their behalf (the agent).

Problems can occur in some situations, with a common one being in the relationship between stakeholders and a CEO. The agent (the CEO) may work in a way that’s not in line with the priorities and goals determined by the principal ( the stakeholders) and instead act in their own self-interest.

Another typical example of the principal-agent dilemma occurs when the agent takes excessive risk because the principal bear the burden. For example, a trader can use extreme leverage to chase a performance bonus, knowing the organization will cover any downside.

DAOs solve the principal-agent dilemma through community governance. Stakeholders aren’t forced to join a DAO and only do so after understanding the rules that govern it. They don’t need to trust any agent on their behalf and instead work as a part of a group whose incentives are aligned.

Token holders’ interests align as the nature of a DAO incentivizes them not to be malicious. Since they have a stake in the network, they will want to see it succeed. Acting against it would be acting against their self-interests.

Note: Part three coming up soon. What was The DAO? What are the Disadvantages of DAOs?