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Over the last year the DeFi Ed team has helped out a few projects directly with things ranging from tokenomics to security.
We know many of our readers have aspirations to become crypto founders. And nearly everyone is either a user or investor in DeFi.
Today we give a high level overview of why founders, investors, and even users of DeFi protocols need to think carefully about governance.
You’ll learn what to avoid doing as a founder to save yourself months of pain in the future, red flags for poorly run protocols, and some less obvious ways ordinary users can be affected by DeFi governance gaps.
The Governance Gap
Business disputes in crypto are more common than you might expect.
Even high quality projects like DeFi Llama experienced a public spat between its two founders that nearly split the project.
Operating in an unregulated field with international (and often anonymous) participants creates a unique set of problems. Investors should be aware these issues may arise and develop a sense for what problems are resolvable and what are likely to lead to a downward spiral for projects.
In crypto there is often a significant discrepancy between what token holders perceive and the actual inner workings of a project - this is the Governance Gap.
It isn’t unique to crypto, just another variation of the well studied principal-agent problem. Solving the problem in a decentralized, anonymous cross-border context poses several additional challenges.
The principal-agent problem arises when one person (the agent) is allowed to make decisions on behalf of another person (the principal). In this situation, there is a risk that the agent will act in their own best interests, rather than those of the principal. Asymmetry of information, where the agent typically has more information about their actions or intentions than the principal, and differing incentives or goals increases this risk. The problem is common in many situations, including in DeFi protocol management, where the team (agents) may not act in the best interests of token holders (principals).
Business Disputes in DeFi
Resolving business disputes in DeFi can be an extremely complex task. Here are some important ways that protocol disputes can differ from traditional business.
Anonymity: In off-chain business disputes, the parties involved usually have a reputation to uphold. From a game theory perspective, they anticipate participating in an "iterated game" where their future prospects hinge on their relationships and their reputation for honesty and competence. While a cartoon persona may also have a valuable reputation, high stakes could incentivize defection (cheating). This isn’t a reason to avoid anon teams completely, but as a founder or investor you should be aware of incentives.
Access to Assets: in certain situations, one party might wield operational control over critical technology components, such as oracle servers, smart routing logic, or bridge validators. They could also have influence over treasury multi-signature holders. Unlike traditional commerce where access to key business elements is stringently regulated by corporate governance, and aggrieved parties can resort to court orders - enforceable by banks or technology providers - DeFi operates differently. The party with practical control often has significant leverage.
Legal Uncertainty: we recommend only using law firms which are up to date on blockchain generally and DAOs specifically. Disputes involving DeFi protocols will typically introduce the following complexities:
Absence of contracts. Lawyers may have to spend many billable hours reviewing all correspondence to discern the legal relationship, rights, and obligations of the parties.
Cross-border issues. Parties might be located in different countries, and there may be no agreement on which legal system governs the protocol or any disputes arising from it. This can pose an additional challenge when seeking legal recourse, namely convincing a court to accept jurisdiction.
Ambiguous constitution. The DAO or token holders' powers might not be explicitly defined, leading to uncertainty when unusual actions need to be undertaken. Does the organization have authority to dissolve itself? Pay dividends? Borrow money? Make IP licensing deals? Cover legal representation costs for its managers? What actions can management undertake, and which also require the approval of token holders? Under what conditions can an employee-token holder forfeit or be forced to sell back their tokens? In private businesses, these matters are usually comprehensively addressed by a company constitution and supplementary shareholder agreements.
Optics. Business disputes in a private Company will usually be kept private. Information may sometimes be shared on a “need-to-know” basis with affected customers, employees, or suppliers. Given the community-driven nature of DeFi many disputes will necessarily involve token holders. This means public statements. It can often be challenging for parties in a dispute to reach a consensus on a joint statement or a public relations plan. The temptation to publicly accuse the opposing side of misconduct may be strong. Optics should be managed carefully, balancing the obligation to make truthful disclosures with the business requirement to preserve investor confidence and shield the protocol from bad publicity.
Secondary markets. A public Company has to comply with special disclosure rules in recognition of the fact that any member of the public may purchase its equity in public markets. In addition to periodic reporting (10-Q, 10-K) the company must make disclosures for material adverse events which could negatively impact the Company. DeFi protocols are usually run like private companies, but with the additional complication that their governance tokens are available for purchase on secondary markets (DEX). If the protocol does not promptly disclose material events it may lead to liability for losses suffered by anyone who purchased (or did not sell) the tokens in the period before the news becomes public. Would a significant dispute which could lead to the failure of the business be such a material event? How much time can management take to resolve the issue before disclosing to token holders? This is all very uncertain.