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For profit DAO Legal Framework [DRAFT]

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Ivelin Ivanov edited this page Aug 17, 2022 · 64 revisions

Note: This document does not provide any legal or financial advise. It is only available for educational purposes.

There are 3 main regulatory aspects to consider when creating a DAO: legal entity, securities compliance and tax compliance.

Web3 is an emerging field of legal research and lobbying. Government regulators in the US have not yet introduced clear guidelines and legislature that fit the egalitarian nature of DAOs. That makes web3 builders feel like they are walking through a minefield.

Still there are several best practices that are becoming popular and allow DAOs to be in a much better position than they would be without any proactive effort for legal protection, securities and tax compliance. The following reports provide a good introduction to this subject as of May 2022:

KaliDAO provides one possible solution to the legal entity aspect of DAOs. KaliDAO's Ricardian Series LLC approach enables new for-profit DAOs to be created with a click of a button by minting an NFT for a series LLC under the Ricardian Master LLC. Each NFT is attached to a new instance of the KaliDAO smart contract which provides a number of benefits and features for web3 builders to get started. KaliDAO also provides the flexibility for founders to attach their own LLC, UNA or other legal entity to the smart contract. In essence KaliDAO provides on-chain legal presence of a DAO with the following properties:

  • Limitation of Liability
  • Corporate Personhood
  • Tax Entity

SporosDAO builds on the KaliDAO foundation and tries to address the other two regulatory aspects:

  • Securities compliance
  • Tax compliance.

SporosDAO is mainly focused on web3 devcos (deSaaS products) in a very early bootstrapping stage, when founders and several contributors get together to solve a problem that they are passionate about. This is the stage before VC fundraising. This is also the stage (first 12 months) when 90% of startups quit.

Can we do better than 10% survival rate if we combine what we've learned from the open source software community with a better incentive design? You can read more about our mission here and our Sweat Equity Collective hypothesis here.

The following diagram illustrates the high level architecture of the SporosDAO stack.

Modified LLC Operating Agreement

The SporosDAO LLC Operating Agreement will be consistent with the KaliCo Ricardian LLC Master LLC Operating Agreement and will modify the initial Series LLC Operating Agreement [Schedule C of KaliCo Ricardian LLC Company Agreement]. The updated SporosDAO Series LLC Operating Agreement will address the following key provisions:

  • Identifies / doxxes the initial founding members of the SporosDAO LLC.
  • Clarifies that there are no other members with any interest in the SporosDAO LLC.
  • The doxxed member(s) will be responsible for interaction with authorities, legal and tax advisors:
    • Option 1:
      • Obtaining Tax ID (EIN) on behalf of the LLC.
      • Filing Form 8832 to elect c-corp tax treatment for the LLC in order to simplify tax filing. 21% flat corporate tax on behalf of the company. No K-1s for individual members with pass through tax obligations from the LLC that they'd have to personally carry without 8832 election.
      • If necessary, establish a bank account on behalf of the LLC linked to the DAO on-chain treasury.
    • Option 2:
      • An alternative to 8832 election could be for the LLC to have a single doxxed member in the form of a Delaware C-corp (let's name it DevCoDoxxed, Inc).
      • In this scenario, DevCoDoxxed, Inc would be the single member of NewDevCo DAO LLC.
      • Since the default tax treatment for single-member LLCs is pass through, there won't be a need to obtain a separate EIN for the LLC.
      • DevCoDoxxed, Inc. will be exclusively dedicated to servicing NewDevCo LLC.
      • DevCoDoxxed, Inc. will not have any transactions outside the ones required for the needs of NewDevCo LLC.
      • This setup also allows for the use of the same 21% Tax Vault automation as in the case of 8832 election for the LLC.
      • Furthermore in this case the warrants issued to contributors (see below) could be tied to a future liquidity event for DevCoDoxxed, Inc.
      • If the supermajority of contributors votes to accept a Qualified Equity Investment or a liquidity event, their voting tokens can convert proportionally to DevCoDoxxed, Inc. shares.
      • Note that this allows contributors the flexibility and collective power to control their destiny and decide via vote whether and on what terms to accept a financing or a liquidity event. This is very different from the traditional way of few c-corp board members making such decisions from an ivory tower.

Note: KaliDAO's Delaware LLC Operating Agreement template includes language for tax representation:

7.5 Tax Representative. The Members shall select a "Tax Representative," who shall be the "partnership representative" of the DAO LLC within the meaning of Section 6223(a) of the Internal Revenue Code of 1986. If any state or local tax law provides for a partnership representative or person having similar rights, powers, authority or obligations (including as a "tax matters partner"), the Tax Representative shall also serve in such capacity. The Tax Representative may resign at any time. If a Tax Representative ceases to serve as such for any reason, the DAO LLC itself will automatically and immediately become the new (acting) Tax Representative until a new Tax Representative is selected by the Members as provided in this Agreement.

Note: The following part of the default KaliCo Series LLC which defines as LLC Members all parties controlling the private key of the Series Ethereum Address would need to be modified to satisfy the list of changes above and clarify that members are the parties who deployed the initial DAO contract (the founder/s), but not parties who obtain voting voting sweat tokens:

THIS LIMITED LIABILITY COMPANY AGREEMENT (this “Agreement”) of KaliCo Ricardian LLC, [RicardianId] Series, a Delaware limited liability company (the “Company”), is effective among the party or parties controlling the private key of the Series Ethereum Address (as defined below) (such party or parties, the “Members”). The acceptance and formation of this KaliCo Ricardian LLC Series shall be evidenced by a Ricardian Mint. All capitalized or highlighted terms not otherwise defined herein shall have the meanings ascribed in the Limited Liability Company Agreement of KaliCo Ricardian LLC (the “Master LLC Agreement”).

  • Irrevocably delegates voting on behalf of all SporosDAO LLC members to its KaliDAO smart contract with Arbitrum One (Ethereum secured Level 2 chain) mainnet address 0x28FEac06Dc72188b385478b507f7c7a39a7026d5.
    • This clause will clarify and ensures that doxxed members do not retain any voting power and cannot make executive decisions without approval via DAO-wide vote.

Note: Delaware LLC law allows members to delegate voting irrevocably:

https://delcode.delaware.gov/title6/c018/sc04/index.html

§ 18-407. Delegation of rights and powers to manage.

Unless otherwise provided in the limited liability company agreement, a member or manager of a limited liability company has the power and authority to delegate to 1 or more other persons any or all of the member’s or manager’s, as the case may be, rights, powers and duties to manage and control the business and affairs of the limited liability company, which delegation may be made irrespective of whether the member or manager has a conflict of interest with respect to the matter as to which its rights, powers or duties are being delegated, and the person or persons to whom any such rights, powers or duties are being delegated shall not be deemed conflicted solely by reason of the conflict of interest of the member or manager. Any such delegation may be to agents, officers and employees of a member or manager or the limited liability company, and by a management agreement or another agreement with, or otherwise to, other persons, including a committee of 1 or more persons. Unless otherwise provided in the limited liability company agreement, such delegation by a member or manager shall be irrevocable if it states that it is irrevocable. Unless otherwise provided in the limited liability company agreement, such delegation by a member or manager of a limited liability company shall not cause the member or manager to cease to be a member or manager, as the case may be, of the limited liability company or cause the person to whom any such rights, powers and duties have been delegated to be a member or manager, as the case may be, of the limited liability company. No other provision of this chapter or other law shall be construed to restrict a member’s or manager’s power and authority to delegate any or all of its rights, powers and duties to manage and control the business and affairs of the limited liability company.

  • Clarifies that tokens provide only governance participation but no ownership rights of any kind.

Note: This approach is well documented in the Tracer DAO contract source code committed on-chain.

READ THIS PARTICIPATION AGREEMENT ("AGREEMENT") CAREFULLY BEFORE CONFIRMING YOUR INTENT TO BE BOUND BY IT AND PARTICIPATING IN THE TRACER DAO. THIS AGREEMENT INCLUDES THE TERMS OF PARTICIPATION IN THE TRACER DAO. YOU UNDERSTAND, AGREE AND CONFIRM THAT:

  1. THE TRACER DAO IS AN EXPERIMENT IN THE FIELD OF DECENTRALISED GOVERNANCE STRUCTURES, IN WHICH PARTICIPATION IS ENTIRELY AT YOUR OWN RISK;
  2. THIS AGREEMENT HAS LEGAL CONSEQUENCES AND BY ENTERING INTO THIS AGREEMENT YOU RELEASE ALL RIGHTS, CLAIMS, OR OTHER CAUSES OF ACTION WHETHER IN EQUITY OR LAW YOU MAY HAVE AGAINST TRACER DAO SERVICE PROVIDERS OR OTHER TRACER DAO PARTICIPANTS. YOU ALSO AGREE TO WAIVE AND LIMIT ANY POTENTIAL LIABILITY OF TRACER DAO SERVICE PROVIDERS OR OTHER TRACER DAO PARTICIPANTS;
  3. YOU ARE SOPHISTICATED AND HAVE SUFFICIENT TECHNICAL UNDERSTANDING OF THE FUNCTIONALITY, USAGE, STORAGE, TRANSMISSION MECHANISMS, AND INTRICACIES ASSOCIATED WITH CRYPTOGRAPHIC TOKENS, TOKEN STORAGE FACILITIES (INCLUDING WALLETS), BLOCKCHAIN TECHNOLOGY, AND BLOCKCHAIN-BASED SOFTWARE SYSTEMS;
  4. YOU UNDERSTAND THAT ALL GOVERNANCE TOKENS RELATED TO THE TRACER DAO ONLY ALLOW HOLDERS TO PARTICIPATE IN THE TRACER SYSTEM VIA ITS GOVERNANCE MECHANISM AND PROVIDE NO OWNERSHIP OR ECONOMIC RIGHTS OF ANY KIND;
  5. YOU ARE NOT CLAIMING OR RECEIVING ANY GOVERNANCE TOKENS FOR A SPECULATIVE PURPOSE AND NOT ACQUIRING A TRACER DAO TOKEN AS AN INVESTMENT OR WITH THE AIM OF MAKING A PROFIT. YOU FURTHER REPRESENT AND WARRANT THAT YOU ARE AN ACTIVE USER OF BLOCKCHAIN TECHNOLOGY AND BLOCKCHAIN-BASED SOFTWARE SYSTEMS. IF YOU ARE CLAIMING OR HAVE CLAIMED A GOVERNANCE TOKEN YOU ARE OR HAVE DONE SO ONLY TO PARTICIPATE IN THE TRACER DAO EXPERIMENT AND TO PARTICIPATE IN TRACER DAO GOVERNANCE-RELATED DECISIONS;
  6. IF A DISPUTE CANNOT BE RESOLVED AMICABLY WITHIN THE TRACER DAO, ALL CLAIMS ARISING OUT OF OR RELATING TO THIS AGREEMENT OR THE TRACER DAO SHALL BE SETTLED IN BINDING ARBITRATION IN ACCORDANCE WITH THE ARBITRATION CLAUSE CONTAINED HEREIN;
  7. BY ENTERING INTO THIS AGREEMENT YOU ARE AGREEING TO WAIVE YOUR RIGHT, IF ANY, TO A TRIAL BY JURY AND PARTICIPATION IN A CLASS ACTION LAWSUIT;
  8. THIS AGREEMENT WILL BE DEEMED TO BE DIGITALLY SIGNED IF YOU SUBMIT ANY TRANSACTION TO THE TRACER SYSTEM ON THE ETHEREUM BLOCKCHAIN WHETHER VIA DIRECT INTERACTION WITH ANY SMART CONTRACT WHEREIN THIS AGREEMENT IS STATED, REFERENCED OR BY INTERACTION WITH ANY OTHER VOTE INTERFACE INCORPORATING THIS AGREEMENT. ANY SUCH DIGITAL SIGNATURE SHALL CONSTITUTE CONCLUSIVE EVIDENCE OF YOUR INTENT TO BE BOUND BY THIS AGREEMENT AND YOU WAIVE ANY RIGHT TO CLAIM THAT THE AGREEMENT IS UNENFORCEABLE OR OTHERWISE ARGUE AGAINST ITS ADMISSIBILITY OR AUTHENTICITY IN ANY LEGAL PROCEEDINGS;
  9. PARTICIPATING IN THE TRACER DAO UNDER THIS AGREEMENT IS NOT PROHIBITED UNDER THE LAWS OF YOUR JURISDICTION OR UNDER THE LAWS OF ANY OTHER JURISDICTION TO WHICH YOU MAY BE SUBJECT AND YOU ARE AND WILL CONTINUE TO BE IN FULL COMPLIANCE WITH APPLICABLE LAWS (INCLUDING, BUT NOT LIMITED TO, IN COMPLIANCE WITH ANY TAX OR DISCLOSURE OBLIGATIONS TO WHICH YOU MAY BE SUBJECT IN ANY APPLICABLE JURISDICTION); AND
  10. YOU HAVE READ, FULLY UNDERSTOOD, AND ACCEPT THIS DISCLAIMER AND ALL THE TERMS CONTAINED IN THE PARTICIPATION AGREEMENT.

Note: KaliDAO's Delaware LLC Operating Agreement template includes language to this effect:

5.1.2 Except as otherwise provided in this Agreement, all decisions and documents relating to the management and operation of the DAO LLC shall be made and determined by recorded votes of the Members' interests in the DAO LLC secured and denominated on a public blockchain ("Cryptographic Units") under the then-existing consensus rules of such Cryptographic Units as detailed on Schedule 1 (such determination, "Cryptographic Consensus").

TracerDAO's Participation Agreement also covers several other important aspects:

  1. An explanation of Tracer DAO’s governance mechanism;
  2. DAO members releasing other DAO members from claims arising in connection with the Tracer project;
  3. DAO members waiving their claims against other DAO members;
  4. A limitation of liability for DAO members in relation to loss or damage arising under or in connection with the use of Tracer’s contracts; and
  5. In-built complaints and dispute resolution procedures for problems and disputes arising in connection with the Tracer project.

Note: a16z's Open Source governance delegation agreement: The a16z governance delegation agreement is a helpful reference for delegating voting rights from one token holder to another.

  • Separately warrants that governance tokens may convert to ownership in the future if and when there is a Qualifying Investment/Liquidity Event.

Note: Mike Rossetti developed an LLC Operating Agreement for Slicing Pie Grunt Funds which are conceptually similar to Sweat Token Smart Contracts. The Grunt Fund LLC Operating Agreement is available here. It outlines how Grunt Fund participation converts to ownership upon certain trigger events (investment, acquisition, etc).

Note: One page SAFT includes simple definition of Qualifying Investment/Liquidity event:

If a Next Token Pricing or Public Distribution Event occurs, the Investor will obtain Future Token Rights on the date of such Next Token Pricing or Public Distribution Event.

Note: LexDAO Token Warrant is another relevant reference designed for angel investors participating in crowd token sales.

  • Limits fiduciary duties and managerial responsibilities of SporosDAO LLC members.
    • This protects doxxed members from being liable for decisions that the DAO executes via on-chain vote against doxxed member's interests.
    • Since all voting is irrevocably delegated to the smart contract, doxxed LLC members have very limited ability to act on behalf of the LLC without an approval vote from smart contract token holders.
    • doxxed members can be expected to:
      • interact with accountants to file taxes on behalf of the LLC.
      • interact with attorneys on matters concerning the LLC interests.
      • interact with off-chain business insurance companies if on-chain are not available.
    • There may not be any other responsibilities that doxxed LLC members are authorized and expected to perform on behalf of the LLC.

Note: doxxed members can be physical persons or legal entities (such as LLC or C-Corp). We can anticipate the emergence of specialized agencies that service for-profit DAOs in the role of doxxed members who help with tax, legal, insurance or banking matters that cannot be resolved entirely on-chain.

Note: The language used in the KaliCo Ricardian LLC Company Agreement which limits fiduciary duties of the KaliCo LLC as a Member of the Master LLC may be applicable in large parts to the doxxed members of SporosDAO. It has the intention of delegating all decisions to the individual Series LLCs members and hence rightfully limits the duties of the Master Member. The SporosDAO Operating Agreement can adopt similar language and defer voting power from the doxxed members to the entities who control the SporosDAO Series LLC smart contract.

4.3 Performance of Duties.

(a) Notwithstanding anything herein or in any Separate Series Operating Agreement to the contrary, the Member does not, shall not and will not owe any fiduciary duties of any kind whatsoever to the Master LLC, any Series, or to any of the members of any Series, by virtue of its role as the Member, including, but not limited to, the duties of due care and loyalty, whether such duties were established as of the date of this Agreement or any time hereafter, and whether established under common law, at equity or legislatively defined. It is the intention of the parties hereto that any such fiduciary duties be affirmatively eliminated as permitted by Delaware law and under the Act, and the Member hereby waives any rights with respect to such fiduciary duties.

(b) Notwithstanding any other provision of this Agreement, any Separate Series Operating Agreement or otherwise applicable provision of law or equity, whenever in this Agreement, the Member is permitted or required to make a decision (i) in its “sole discretion” or “discretion” or under a grant of similar authority or latitude, the Member shall be entitled to consider only such interests and factors as it desires, including its own interests, and shall, to the fullest extent permitted by applicable law, have no duty or obligation to give any consideration to any interest of or factors affecting the Master LLC, any Series or any of the members thereto, or (ii) in its “good faith” or under another expressed standard, the Member shall act under such express standard and shall not be subject to any other or different standards. Unless otherwise expressly stated, for purposes of this Section 4.3(b), the Member shall be deemed to be permitted or required to make all decisions hereunder in its sole discretion.

Automated Tax Vault

Having a predictable 21% corporate tax target, the DAO can implement an automated tax withholding contract that continuously tops up a Tax Vault which will be only unlocked by LLC authorized accountants (or doxxed members) to initiate bank payment to Tax Authorities (IRS).

Note: This a16z paper suggest one possible way to implement this (page 23) for UNA entities, but similar logic should apply to LLCs:

Potentially Automated Tax Calculation: The calculation of tax could be written into the smart contracts at a 21% rate calculated on any disposition of treasury tokens (e.g., treasury diversification sales, token swaps with other DAO treasuries, a hard fork of the governance token or to deposit the funds in a wallet of 501(c)(4) entity associated with the DAO), which could be converted into stablecoins and deposited in the entity’s wallet for the purpose of paying taxes. By writing the 21% rate into any treasury transaction that would result in the recognition of income tax, the DAO would not need to authorize specific proposals to elect to pay taxes, it would be automatic to any taxable event that gave rise to income tax obligations on the treasury tokens, including proposals enacted through governance. In the event the 21% withholding ended in a surplus, the terms of the entity would dictate that the overages be returned to the treasury. In the proposed structures, the entity would be paying income tax in a situation where not only was income tax not being paid previously, but where a clear taxpayer or obligation to pay income tax had yet to be definitively established. As the proposed entity structures results in dominion and control of the treasury assets, they establish a clearly identifiable and appropriate taxpayer for income tax purposes.

Tribute Agreement

To reduce tax and securities compliance filings in the early Sweat Equity stages of DAOs before professional equity investment and liquidity for contributors, we are exploring the use of warrants (vs Profit Interest for LLC membership or Capital Interest for c-corp shareholders).

The idea for warrants is derived from a combination of concepts previously used successfully by reputable organizations such as Founder Institute. The following established agreements can be the basis for a new consolidated SporosDAO Contributor Agreement:

Atomic exchange

A DAO and a contributor agree on exchanging a tribute for DAO tokens in one atomic transaction. Either all of the following steps succeed by both parties signing or all steps fail:

  1. Contributor transfers all rights to ownership of the tribute to the DAO.
  2. DAO transfers negotiated amount of sweat tokens to contributor.
  3. DAO warrants to share future equity with contributor proportional to the amount of DAO sweat tokens owned by contributor.

To unpack the steps of this atomic transaction, when a new SporosDAO contributor wants to make a tribute to the DAO in the form of:

  • professional services (e.g. influencer campaign)
  • intellectual property (e.g. logo design, original software code)
  • capital contribution in NFTs, liquid tokens or other assets such as paid web2 cloud services

Note: The contributor agreement will be closer to an open source CLA that covers transfer of IP and license rights, without triggering a taxation events on phantom income. This is different than a more traditional work-for-hire Contributor Agreement that transfer IP in exchange for currency payment, which triggers taxation events and tax compliance paperwork on behalf of organization and contributor: W-9 (US) / W-8 (non-US contributor), Form 1099 for payments over $600 in a given year.

they digitally sign with their web3 wallet and execute the Tribute Agreement with the DAO, which provides them with:

  • governance voting tokens proportionate to the negotiated value of their tribute
  • ability to use their voting tokens to steer the direction of the DAO as a whole
  • ability to participate in future upside via Equity Collective Warrant terms without triggering complex personal tax events that usually arise from using profit interest grants (for LLCs), stock grants (c-corp) or vesting option grants (c-corp).
  • ability to keep track of their participation in the Equity Collective pool shared on-chain transparently between all DAO contributors.

Note: Because of the form of the warrant agreement, contributors do not become LLC members nor c-corp shareholders, which reduces the events that can trigger doxxing. In the meanwhile they can still guide the DAO via their smart contract votes.

Respectively the signed Contributor Agreement provides the DAO with:

  • Intellectual Property rights for the tribute
  • Developer Certificate of Origin
  • Licensing Agreement for the software code or other digital assets
  • On-chain record of account linking the newly minted tokens to the tribute
  • Ownership of the materials or assets provided via tribute

Note: When the intention is to offer a private sale of tokens to multiple accredited investors in one batch, KaliDAO's 'sale' contract may be more convenient than 'tribute'. KaliDAO is working on streamlining fundraising.

Capital Contributions

It is common for early contributors to help a bootstrapping project with equipment necessary to operate. Capital contribution is a common form but it comes with a long list of tax and equity rules that require an attorney to evaluate the situation and provide advice on a case by case basis.

Another common alternative is leasing personal equipment to the company. However in the early days when there is nothing in the treasury, this is not very realistic.

Until the treasury builds up some value, a reasonable approach is to let the company borrow equipment for free for some limited amount of time. Here is an example of Loan Form that provides the equipment owner legal protection while the equipment is used. Separately the DAO LLC can choose to reward the owner of the equipment with some amount of sweat tokens for the help. This exchange can be packaged in a tribute transaction similar to one used when a contributor provides open source licensed code or graphics design (e.g. via MIT, Apache 2, CC0) in exchange for sweat equity tokens.

Graduation options

The Tribute Agreement will be flexible enough to allow the DAO to graduate from sweat equity stage to its next growth stage. Some typical graduation events are:

  • DAO reaches a Qualified Equity Investment Event.
    • For example over $1M term sheet by a VC firm to help with growth.
    • This may require the governance tokens to transfer into a new smart contract with different tokenomics.
    • This may require the DAO LLC to transition into a Delaware C-corp that most VCs are used to working with.
  • DAO reaches Qualified Liquidity Event.
    • For example there is enough runway, growth momentum and margins to attract community interest to own tokens as investments.
    • Majority token holders vote to enable token transferability and participate in community created DEX LPs.

Note: Graduation from sweat equity stage is not automatic and will likely come with new requirements, filings and processes for securities and tax compliance!

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