V 1.0 of the December 2019 MetaCartel Ventures (MCV) Whitepaper landed on our desk just as we were packing for Christmas. We used the holidays to have a closer read and wanted to use this post to share some comments, primarily on the coupling between MCV’s technology and its legal layer and secondarily, on whether and how legal DAOs such as MCV can gain an edge over traditional VC funds.
MCV’s Folklore and Origins
According to its own folklore, MetaCartel started as a “band of creators with the broad mission of building a better Web 3.0”. Initially however, MetaCartel was perhaps best known for their irreverent memes.
Early 2019, MetaCartel planned the launch of a DApp incubator in the form of a DAO. This resulted in a first fork of the MolochDAO, a grant fund set up to incentivize coordination toward the funding of Ethereum public infrastructure.
The Whitepaper now iterates on MetaCartelDAO’s first grant fund by exploring the concept of MetaCartel Ventures (MCV), a for-profit investment DAO coupled with a legal entity.
The Whitepaper claims MCV is “MetaCartel’s very own unique brew of cryptoanarchy”. If so, it is a more mellow and pragmatic version of anarchy on display that recognizes the need for a real-world legal wrapper around the DAO.
For this, it chose a Delaware Limited Liability Company (LLC). As with all LLCs, it will have its own Operating Agreement (which MCV calls “Grimoire”, a “book of spells” in reference to online games, though Grimoire’s etymology has biblical roots). In addition, MCV will be subject to The Delaware Limited Liability Company Act, the statute and the extensive jurisprudence applicable to all LLCs formed in Delaware.
Despite MCV’s naming, there’s no magic to this setup however it is in the coupling between the legal and technology layer (the latter an instance of the Moloch V2 smart contracts standard) that the innovation lies.
Augmentation or duplication?
MCV’s general approach to this pairing of blockchain technology with law is based on the ZeroLaw Augmentation Paper.
ZeroLaw’s org-Augmentation protocol (ZAP) is a general-purpose tech/law stack for “augmenting” any business entity or organization through the use of smart contracts and shares deployed on Ethereum or any other EVM-based blockchain.
There’s tremendous merit in the deep analysis by the ZeroLaw team and other thinking on limited liability autonomous organizations governed by smart contracts, such as OpenLaw’s LAO.
However, until the law itself recognizes the validity of an organization’s blockchain transactions - such as Wyoming state law which explicitly allows for share transfers in a Wyoming LLC to be recorded using an owner’s blockchain address rather than their name - any attempt at augmentation at the blockchain level will inevitably contain a fair amount of duplication of legacy legal processes in code.
Nonetheless, there is a lot of stuff one can do by abstracting legal logic using smart contracts, stuff that would arguably be more difficult to implement, administer and enforce using traditional legal documentation:
- A fund can be radically community governed (if this is desirable);
- As a result, each member can bring deals, vote on deals, and generally participate in the fund’s running;
- Members can be given an inviolable right to exit (“RageQuit”) whilst retaining a carry in the fund by way of a token.
By wrapping the DOA in an LLC, it can also enter into real-world agreements as a separate legal entity, give its Members limited liability, and (subject to securities laws) issue and receive tokens that are securities.
Life’s full of trade-offs
However, despite (or perhaps as a result of) MCV’s qualified code deference (vs. a strict “code is law approach), its proposed solution is not without trade-offs, which the Whitepaper acknowledges:
MCV’s focus on community governance, combined with its mission of investing in the Ethereum ecosystem on a for-profit basis, has led to a number of legal structuring choices.
The main tradeoffs relate to:
- The inviolable right of each member to leave the fund . Whilst perceived as a major advantage over traditional VC funds, this right creates its own set of challenges that ripple through MCV’s entire design;
- Common denominator (or race to the bottom) investments: MCV’s investment decisions are consensus-based by design, with the RageQuit function protecting any contrarian Member from the tyranny of the majority. The result is that the fund is unlikely to take controversial decisions.
- A third trade-off comes from MCV’s desire to issue and/or buy securities (equity or security tokens) which opens up a whole can of regulatory worms (more on that below).
The above trade-offs, in particular the inalienable right for any Member of the LLC to RageQuit, goes to the very heart of early stage investing.
Rush for the door
Irrespective of the technical feasibility of the RageQuit smart contract, there is the question of its desirability. Demonstrably, much of the outsized returns of traditional VC funds come from a small number of outlier portfolio company investments that have been patiently groomed over the “vintage” of the fund (typically 5 to 8 years).
VCs impose legal gates to investors’ exit rights in order to secure themselves of “patient” capital over the lifetime of the fund. The idea is that new ventures can’t rely on fickle money in their early years (until they float).
By contrast, RageQuit by MCV’s Members is likely to encourage impatient - not to say impulsive! - capital. Small setbacks, management upheavals or dissappointing metrics in any given project may cause Members to rush for the door. This is likely to be at the detriment of the DAO’s aggregate returns. In turn, it will scare potential investors away, resulting in less projects receiving funding.
A second design feature highlighted in the MCV Whitepaper which we believe may work counterproductively is the lack of incentives for individual Members to bring dealflow.
Our concern is that the “diverse due diligence” and “incentivized aggregation of dealflow” which MCV expect from the community do not sufficiently substitute for the incentive mechanisms in place within traditional VC firms.
As General Partnerships, VCs use carefully calibrated payout structures to incentivize their individual General Partners to scavenge for deals. As industry specialists, these GPs take ownership of the due diligence and groom their portfolio companies all the way towards a successful exit, resulting in a big personal payday for the GP.
It is an open question whether the reshuffled incentives proposed by MCV will produce the same zeal and degree of good greed with its Members.
Towards an Improved Design for a Legal DAO Fund
The above objections to a fully community-managed fund do not only come from self-serving VCs but are also alive within the crypto community (see e.g. Mohamed Fouda’s The Uphill Battle LAOs will face).
The goal of democratizing and decentralizing the early stage investment process is considered one of the primitives of the crypto space, in the same way as DeFi defies the lending and banking space.
In this context, MCV is undoubtably one of the most fascinating experiments in how VC could become more inclusive and community-governed.
We believe some relatively minor design tweaks may help enhance this goal. Further iterations may ultimately give legal DAOs an edge over traditional VC.
Each of the ideas below needs to be tested on its merits: all we hope to achieve here is to stimulate further debate.
1. Member liability, tax
Until one day blockchains themselves gain recognition as jurisdictions sui generis, DAOs will still need tethering to a real-world jurisdiction in order to achieve limited liability.
MCV achieves this by incorporating as a Delaware LLC. As highlighted in one of our previous blog posts on Delaware, such LLCs are pass-though vehicles from a tax-point of view, which means Members who receive income from the LLC will need to declare this on their personal income tax form.
We expect next iterations of a legal DAO fund to examine other jurisdictions, including the Cayman Islands where most of the world’s VC funds are incorporated. Cayman has no capital gains tax and generally works better than a US LLC for non-US investors. It also allows for easier tokenization compared to the US.
2. Dealflow and RageQuit
Future forks could also tweak the dealflow model.
In this context, some have suggested that Members of a community-governed legal DAO fund appoint a lead investor who would lead the diligence process and support the deal, similar to the syndication process on AngelList.
This could then be combined with a smartcontractified “carry” to incentivize the individual Lead to bring deals and look after them.
Such smart contract could be coupled with a legal structure that denies Leads the RageQuit freedom in the deals they supported.
Currently, in MCV’s design, if a Member is outvoted by a majority of Members in favor of a new investment, exercising her RageQuit right results in her exclusion from the fund, including the deals that she supported.
Even though the RageQuit token provides for an ongoing carry in the fund’s investments made up to that point, the RageQuit member is entirely at the mercy of other Members in how they support existing portfolio companies and more generally how the fund is governed, which is suboptimal.
Perhaps an alternative legal structure by way of a Series LLC in e.g. Delaware or Wyoming can bring succour here. These Series LLCs allow for individual “cells” hanging underneath the Master LLC, each cell with its own Members, Profit and Loss account and strict firewalls between each cell (and between the individual Series and the Master) to prevent cross-contamination of liabilities.
In essence, in such a setup each cell would be a syndicate in its own right: once a favorable vote took place, a new Series could quickly be fired up to hold and manages the assets of the deal, e.g shares in a portfolio company, tokens issued by a project, debt instruments etc. (Full disclosure: Otonomos is working on an onchain, blockchain-native Delaware Series LLC which allows for Series to be spun up within seconds by making a small DAI payment into a smart contract and which could easily be adapted for this purpose).
The Master itself could be setup by what MCV calls the “Mages”: Members whose role is largely similar to that of the General Partners in a VC fund. Each of the Mages could simultaneously be Members of the Master and one or more Series.
On the governance side, to prevent the emergence of a governing “caste”, mechanisms along the lines proposed by MCV could be used to safeguard “social mobility” between the LLC’s ordinary Series Members (the “Goblins” in MVC’s scheme) and Members of the Master LLC (the “Mages”).
Furthermore, in a Series LLC structure, Members who sourced a deal would forfeit their RageQuit right in that Series. Such restriction could also justifiably be extended to all Members of the individual Series who voted in favour of that deal. This would bring long-term, “patient capital” to Series Members’ chosen project, including crucial follow-on funding (of which MCV makes no mention).
Finally, smart contracts and Series-specific tokens could allow for a degree of dividending at both the Series and Master level which is arguably difficult to achieve (and definitively too cumbersome to administer!) in the paper-based legal world.
Carries could be sliced and diced any way Members see fit, with automatic payouts crediting Members’ wallets pro rata their capital input and/or their active role in the governance of the fund.
In all of this, desirability has to take priority over feasibility: since code is endlessly malleable, shiny new tech solutions ultimately have to prove their superiority over legacy legal solutions that crystallize decades of best practice.
Anybody who follows the governance debate will see significant experimentation with voting mechanisms, including quadratic voting.
We see a significant opportunity to replace some of the traditional majority mechanisms embedded in legacy legal structures, including template LLC Operating Agreements, with new voting models.
These in turn could obviate the need for the type of blanket RageQuit rights proposed in MCV’s WhitePaper and could help narrow down the 8 proposal types it envisages.
The Legal DAO: A Faustian Deal with Securities Laws
Finally, our post would not be complete without at least an attempt to ask the right questions about how legal DAOs and securities laws and regulations interact.
In the case of MCV, by incorporating as a Delaware LLC and awarding Members equity shares (% Membership interests), MCV knowingly entered a Faustian deal with securities laws which no legal DAO is likely to escape (though in some jurisdictions the SEC’s long arm is shorter!).
MCV’s Whitepaper outlines the main issues. Taken together, they impose a significant legal corset that will feel uncomfortable to many in the community who pine for the liberties of the ICO days.
The issue can be broken down in two categories:
1. MCV buying securities including security tokens
As a result of its role as an early stage DApp accelerator fund, it is very likely that MCV will hold most of its investments via the purchase of a project’s tokens, including security tokens, in addition to the direct purchase of equity stakes.
MCV’s Whitepaper also envisages investment via SAFEs and SAFTEs and the purchase of debt.
Since most issuers rely on the accredited investor exemption (the SEC’s “Reg D” safe haven), the MCV as an entity will need to qualify as an accredited investor.
On order to do so, either all of its Members would need to be accredited investors, which is restrictive, or MCV would have to hold assets over USD 5MM.
However, even with assets over USD 5MM, non-accredited Members would have to show “relevant managerial experience” and “maintain a robust managerial role” - in other words be willing to act as General Partners or “Mages” - in order for the fund to maintain its accredited investor status.
This severely dilutes the dream of an inclusive, participatory fund with easy entry and exit for all, however it is what the law prescribes (though changes to the definition of what constitutes accreditation in the US are under way and seem to be going in the right direction, and investors can helpfully self-accredit in the US, which is not the case in many other jurisdictions).
In light of the above, instead of forcing non-accredited Members into a permanent General Partner-type role, MCVs seems to want to go the route of accrediting each and every Member even when it reached assets over USD 5MM. This essentially means compliance checks to whitelist all its Members.
2. MCV as issuer of Membership interests
A second area where securities laws touch on MCV’s activities is when it issues shares to its Members as an LLC.
Securities laws generally require issuers to either register a hare offerings or use an exemption.
Since registration implies an application process and SEC approval (including for a Reg A+ crowdfunded offering under the JOBS Act, which comes with its own restrictions), MCV works on the assumption that it is a General Partnership on the basis that all Members enjoy extensive management and information rights. In this analysis, as “units in a general partnership”, Membership interests would not be considered securities.
The Whitepaper further argues that MCV’s small scale, its symmetric information rights amongst Members (though this is not entirely obvious) and the non-transferability of Membership interests all support its case that Membership interests are not securities.
Some of the above assumptions are still to be tested in the context of a legal DAO, including MCV, in which the acquisition of DAO shares directly from a smart contract at the blockchain level is paired with Membership of an LLC at the legal level, without the Membership shares constituting securities.
Be it as it may, if MCV itself already gained status as an accredited investor by virtue of only having accredited Members so it can buy securities for its fund, perhaps the easier way is to then also offer its Membership interests in the form of security tokens to its Members, and make them transferable.
Not only could this act as a significant decomplexifier to the legal acrobatics of the current design, it may also make the fund more attractive to prospective Members who (subject to securities laws) could trade their tokenized interest on a secondary market.
For a purist DAO grant fund - open to all and governed by its members - to operate in the real world as a legal DAO, it will have to enter a Faustian bargain and compromise on some of its core ideals and principles.
Both as a buyer and issuer of securities, the legal DAOs will be forced to fall in line with securities laws. Whilst this comes with significant trade-offs, many desirable features of a crypto-native DAO grant fund can still be preserved if code gives right deference to law.
MCV’s Whitepaper and other recent initiatives in the legal DAO space show how this “double helix”, consisting of a smart contract technology and a legal strand, is likely to form the basis for a new type of community-managed grant fund.
We believe that the same DNA will eventually be found in next-gen general-purpose venture capital funds, and that innovation in this space will happen from within the crypto-native community in clear defiance of the reigning VC paradigm.