Think about the fit between business and governance: When should decentralized governance be started?

Author: Chris Ahn

Source: Haun Ventures

Startups obsess over product-market fit and business model fit, but they rarely discuss business and governance fit. Web3 has brought renewed attention to this previously neglected concept - certain governance models are better suited to specific projects.

For non-crypto-native projects, choosing the right governance model is relatively simple because of the well-known trade-offs. Even non-experts can answer whether a project is public or private, for-profit or not-for-profit. For crypto-native projects, the decision is more complicated because they must consider a new axis: decentralization.

Decentralized governance allows anyone to contribute without the permission of a central authority. As with historical governance parameters, there are clear tradeoffs to decentralization. Contrary to common belief, it is a tool that can benefit some - but not all web3 projects. Web3 founders should weigh whether their projects might benefit from decentralized governance.

Historical Governance Model

Historically, governance decisions have been based on two considerations: for-profit versus not-for-profit, public versus private.

• Public for-profit companies such as Apple have a dispersed base of shareholders who elect and manage boards of directors.

• Private for-profit companies like Fidelity have a concentrated shareholder base and have historically been family-owned.

• Public not-for-profit entities such as public universities and hospitals are governed by a board of directors, of which more than 50 percent of the directors must not be affiliated with the organization. Also, profits cannot be distributed outside the organization.

• Private nonprofit entities like the Gates Foundation typically have a limited number of donors and are not required to have outside directors.

The most striking feature of these historical governance models is that people can only contribute through appropriate permissions (usually through employment). Except for open source projects (which usually don't operate like formal organizations), it's impossible for someone to simply contribute to a project. To contribute (aka work) to Apple, Fidelity, a university, or the Gates Foundation, you must first be an employee, work hard and be trusted.

When MakerDAO decided to hold its first public MKR vote in 2018, it began an experiment in decentralized governance. Since then, some of the most prominent projects in web3 have adopted decentralized governance, including Uniswap ($7.4 billion), Compound ($521 million), Aave ($1.4 billion), Curve ($4.1 billion) and dYdX ($2 billion). These five projects alone account for over $15 billion in fully diluted market capitalization (as of July 25, 2022). Many more valuable decentralized projects will emerge in the future.

The importance of business and governance fit

Choosing the right governance model is a critical decision for founders, as the right model can serve as a strategic advantage. Governance conveys two key signals about an organization:

• promise. When a business chooses a governance model, it communicates the goals of the organization. Think about the difference between Facebook Messenger and Signal. Signal's status as a nonprofit reinforces its user-first, privacy-preserving value proposition, as it clearly has no ulterior motives. Many users therefore trust and remain loyal to Signal. One area where Facebook Messenger can't compete with Signal, even when it's feature-matched and network effects strong, is mission.

• decision making. Each governance model comes with its own decision-making framework that determines who makes decisions at which level. For example, public companies are ultimately accountable to a board of directors that represents a broader shareholder base, while private institutions are accountable to a majority of shareholders. Decisions made at board meetings tend to be high-level decisions, while strategic and tactical decisions to implement the high-level direction set by the board are left to employees.

Why go to centralization?

Decentralization is a unique governance mechanism because it invites anyone to contribute without permission. For example, why would an organization want more celebrity chefs in the kitchen, even though it might slow down and sometimes even stall it? Using the same framework as above, decentralization communicates the following:

• promise. It signals the desire to align with the organization's user community to the greatest extent possible. In historical governance structures, users' greatest contribution to the project without becoming employees was by providing product feedback in designated channels, or by voting on specific shareholder resolutions. Since decentralized governance invites anyone to contribute, decentralized projects coordinate and directly engage the community in what and how they develop.

• decision making. Decentralized governance transfers decision-making and enforcement to the community at every level. The community decides which changes to implement by voting on proposals. It can also propose and implement improvements, including detailed product improvements that would otherwise be in the hands of employees.

In many respects, the case of decentralized governance is similar to that of public permissionless databases such as blockchains. While the latter is slower and more expensive than the centralized approach, one aspect — permissionless participation — is unique in that it opens up a whole new value proposition that was never possible before.

The most common criticism of decentralized governance is that more participants mean a less efficient organization. This criticism is undoubtedly correct. An organization with 5 decision makers has 10 possible communication channels, while an organization with 100 decision makers (a 20-fold increase) has 4950 channels (a 495-fold increase). As the number of people increases, the burden of getting people to agree grows exponentially — which is why, in politics, dictatorships make decisions faster than democracies, and in business, private companies are more nimble than public companies.

One way to justify decentralized governance is to answer the question: Are organizations that optimize for diverse perspectives worth competing with organizations that optimize for quick decision-making? For those fortunate enough to live in democracies, the analogy should resonate. Sometimes the axis of optimization is not speed or cost, but broad representation. Doing so can yield longer-lasting and more valuable results than projects built solely for speed.

Choose Decentralized Governance

Just like not every for-profit organization aspires to go public, not every web3 project needs to be decentralized. Organizations where this governance mechanism represents a strategic advantage are protocols. Protocols are solidly neutral projects that want to solve the same needs for users for as long as possible. The protocol has three characteristics:

1. reliability. When a product wishes to take advantage of the protocol, the most important consideration is reliability. Will this protocol do what I need 100 years from now as reliably as it does today? Do I have any input on potential changes? For the protocol, the choice of decentralized governance demonstrates its intention to maximize alignment with those who wish to build products on top of it, and provides a direct path for these builders to have a say in the development of the protocol.

2. Small product surface area. Protocols are designed to be the lowest common denominator abstraction that other products can leverage. Therefore, they tend to have a smaller product surface area. This is desirable for decentralized governance, since such decisions are already complex with only a single product feature; the extra product surface area makes the decision even more complex.

3. standardization. A successful state for a protocol is to become a standard with network effects. Each incremental product built on a protocol makes the next protocol more valuable. Decentralized governance helps the protocol become a standard by providing a product that one can directly participate in by convincing others to join.

Furthermore, decentralization is not a binary choice, but a floating scale. Protocols should choose the level of decentralization that is strategically appropriate for them, as it has a clear trade-off in execution complexity. This can be achieved by deciding what level of decision-making will co-exist with communities and pre-defined (sometimes elected) teams.

This may be debatable, but non-protocol web3 projects may find decentralized governance useless. As a non-protocol project, the goal of the project is growth. Growth is achieved by providing additional product features for more users and different use cases. As a result, the surface area of the product will become larger and end up unreasonably managing many decision makers.

Towards a Modular Future

Choosing the right governance mechanism is a strategic advantage for any organization, and the decision to decentralize is no exception. Protocols now represent the best type of project to take advantage of decentralized governance.

It is conceivable that in such a world, modular decentralized protocol blocks will exist alongside independent applications. This parallel universe is difficult to create and is full of failed prototypes. But it's an exciting experiment to be a part of - an alternative built by the community for the community and best aligned with users' interests.