What is a Pyramid Scheme?

You're outside cutting the lawn and your neighbor pulls up in a brand-new BMW. He's wearing a suit and carrying a briefcase. You've never seen this guy out of his sweatpants. Maybe a millionaire uncle died?

After some small talk, you ask him what's up with the new car and the new suit. He acts all coy and says he just got lucky with a new type of business opportunity. You're curious, so you ask for more details.

He says he's become a freelance distributor for a health supplement company. Turns out that there are tons of people out there who will pay big bucks for his products. And even better, the more salesmen he hires to work for him, the more money he makes. For a one-time sign-up fee, plus the cost of the merchandise, you could start doing the same thing tomorrow. "Hire 10 salesmen," he says, "And you'll have your own BMW in a month."

Wow, you think, this is the real deal. No more office work, no more bosses, just managing a team of salesmen from home. You go for it. You hand your neighbor a check, collect your starter kit of supplements and start hitting the phoneslooking for potential salesmen.

You call your buddy Bob to see if he's interested. But the weird thing is, Bob ran into your same neighbor yesterday at the grocery store and also signed up to be a distributor. What's worse, Bob's already been calling around, and it looks like your neighbor and his buddies have already signed up half the city.

"Nobody's going to want to buy from us because we're all trying to sell!" cries Bob. "And we'll never make our money back on salespeople because there's no one left to recruit!"

Looks like you've been suckered in by a pyramid scheme. Your neighbor and his buddies are at the top of the pyramid. They got in early and made money by recruiting people like you. But now you're competing with hundreds of other distributors for the same small pool of potential recruits. The odds of making your money back are worse than roulette in Vegas [source: Taylor].

So who makes money and who loses it in a pyramid scheme? And what are some signs that a fabulous "business opportunity" is really a pyramid in disguise? Read on to find out.

What is a Pyramid Scheme?

The main characteristic of a pyramid scheme is that participants only make money by recruiting more members. There are many different kinds of pyramid schemes, but the two most basic are product-based and so-called naked pyramid schemes.

In a naked pyramid scheme, no product is sold. Here's how it works:

One person recruits 10 other people to participate in a "no-fail investment opportunity."
The 10 recruits each pay the recruiter $100.
The recruiter now tells them to go out and recruit 10 more people to do the same.
If each recruit is successful, they'll all end up with $900 in profit from a $100 investment.

Sounds simple enough, but here's the problem: Let's say the initial 10 recruits each find 10 more people. Those 100 new recruits will have to find 10 recruits each to make $900. That means they have to find 1,000 people willing to sign up for the program. And if they somehow find 1,000 people, that next level of the pyramid will need to sign up 10,000 to make a profit. Eventually, there won't be enough recruits at the bottom of the pyramid to support the level above it. That's when the pyramid topples and everyone at the bottom loses their investment.

A product-based pyramid scheme is the same concept disguised as a legitimate direct sales opportunity. Here's how it works:

A distributor recruits 10 salespeople who each pay $500 for a starter kit of products to sell.
The distributor gets 10 percent of each starter kit that's sold.
The distributor also gets 10 percent of each product that any of his recruits sells, including more starter kits.
The recruits are told that the fastest way to make money isn't by selling products, but by recruiting more people to buy starter kits.
The people at the top of the pyramid get commissions from everyone in their downline, the many levels of recruits below them on the pyramid.

The problem with most product-based pyramid schemes is that the products themselves don't sell very well, or have very slim profit margins. So the only way to make money is to find more recruits. Eventually (and surprisingly quickly), the market becomes saturated. There are too many people trying to sell the same unattractive product and there's no one left to be recruited.

It's mathematically impossible for everyone to make money in a pyramid scheme. For example, if each recruit needs to find 10 more people to recoup the cost of his or her initial investment, the eighth level of the pyramid would have to recruit a billion people to make back their money. And the next level would need 10 billion, nearly twice the population of the Earth.

In fact, pyramid schemes don't work unless somebody loses. Those at the bottom of the pyramid are essentially defrauded by those on top. It's a mathematical fact that no matter how many people join a pyramid scheme, 88 percent of the members will be on the bottom level and will lose their money [source: Pyramid Scheme Alert]. Pyramid schemes are illegal because people don't lose their money due to normal market forces, but because the system requires them to lose so that a few at the top will win.

Studies show that in a naked pyramid scheme, 90.4 percent of people lose their money, while in product-based pyramid schemes, that number jumps to a shocking 99.88 percent [source: Taylor].

So what's the difference between product-based pyramid schemes and legitimate multi-level marketing (MLM) companies? Or is there even such a thing as a legitimate MLM? Read on for more info.

Multi-Level Marketing and Pyramid Schemes

Multi-level market (MLM) or network marketing is an American institution. Companies like Amway, Tupperware, Herbalife, Avon, Mary Kay and The Pampered Chef support huge networks of distributors and recruits who sell every type of product from dietary supplements to kitchenware to beauty products. Salespeople are called independent business owners (IBO) and generally work from their homes.

On the surface, it's hard to tell the difference between a legitimate MLM and a pyramid scheme. That's because they're both built on the business model of "multiple levels" of distributors and recruits. Some critics of MLMs claim that all of them, even the supposedly "legitimate" ones, are pyramid schemes in disguise.

In a landmark 1979 ruling, the Federal Trade Commission found that Amway was not a pyramid scheme. That ruling has paved the way for hundreds of MLMs to follow Amway's business model. The Amway Web site highlights the differences between its unique "business opportunity" and a pyramid scheme:

Amway doesn't pay distributors for simply recruiting new salespeople.
The only way to make money through Amway is either by selling products directly to consumers or by managing a team of salespeople. Managers get a percentage of each of their recruits' sales.
Amway doesn't require its salespeople to buy starter kits or impose a minimum monthly order value to stay a member. [source: Amway]

Amway stresses that the main difference between a legitimate MLM business model and a pyramid scheme is that a legitimate MLM is focused on selling products, not recruiting more salespeople. In a legitimate MLM, it should be possible to make money by simply selling products directly to customers. With that main criterion in mind, here are some other ways to identify product-based pyramid schemes:

Pyramid schemes offer money for simply recruiting people. This money can come as a commission from the sale of a starter kit or as a recruiting "bonus."
Avoid any MLM that puts much more emphasis on recruiting salespeople than selling the actual product.
Pyramid schemes charge steep startup costs for joining, including mandatory training, a starter kit and a non-refundable membership fee.
Beware of any MLM that allows five or more levels of distributors to collect commissions on a single sale.
Make sure that the products being sold have real value and a competitive price. Are they reputable brands? Have the manufacturers been involved in recent lawsuits?
Avoid MLMs that only sell lists of sales leads to other MLM salespeople. This is most likely outdated information that has made the MLM rounds several times before.
Avoid signing up for an MLM as part of a high-pressure motivational event. Consider the information carefully and take it home to think about it.
Be wary of anyone who tries to sell you on an MLM by flaunting their personal wealth. Realize that many of the people who claim to have made millions through MLM have actually made their money selling books and videos on how to make millions through MLMs.
Bottom line: If it sounds too good to be true, then it probably is.

Now let's look at some of the most famous pyramid scheme scams from the past and present.

Famous Pyramid Schemes

One famous type of pyramid scheme is known as a gifting scheme. These often have names like dinner party, women empowering women, dinner club, circle of friends or women's empowerment network. This scheme is a naked pyramid scheme in which new participants "buy in" with a set amount of money that is "donated" to the person who recruits them. They, in turn, are required to recruit more people. As you collect more recruits, you move up the pyramid, sometimes with colorful names like the "salad level" and "dessert level" [source: Pyramid Scheme Alert]. Recruits are promised a substantial lump sum once they reach the peak level. These schemes often target women with the idea that through collective donations they're helping each other earn more money.

A Ponzi scheme is a fraudulent investment plan in which the money isn't invested at all. Instead, every new investment is used to pay off earlier investors. In 1920, Charles Ponzi ran a scam promising New Englanders a 50 percent rate of return in 45 days for a convoluted investment involving international mail coupons [source: The New York Times].

Ponzi ended up collecting $10 million and paying back $8 million, leaving a cool $2 million for himself. He served back-to-back federal and state prison sentences for mail fraud. A Ponzi scheme isn't a pyramid scheme because the fraud is centralized -- controlled by one person or entity -- instead of being spread across a network of people who willingly or unwillingly perpetrate the crime.

Affinity schemes are pyramid schemes that target certain ethnic or religious groups. The scammer presents him or herself as a member of that group and sells the pyramid scheme as a way for people to "give back" to the community while providing job opportunities for other members [source: New York State Office of the Attorney General]. Scammers try to lure in prominent members of the community first to set an example.

One of the hottest pyramid schemes continues to be the penny stock scams that are promoted through spam e-mail messages. The e-mails tout "incredible investment opportunities" to get in "on the ground floor" on a stock that's about to "take off!" The inner workings of penny stock schemes are complicated, but here's an overview:

The perpetrators of the scam create a shell company without any assets or organizational structure, just a name and a stock symbol.
The stock is offered to the public for pennies a share with the promise that the shell company will soon be merged with an existing public company with actual revenue.
Only 20 percent of the stock is actually sold to the public. The scammers control the other 80 percent, ensuring a cash windfall from the initial public offering (IPO).
Even at only a penny a share, stockholders are grossly overpaying since the company has no real value.
After the initial public offering, the stock price goes up and the perpetrators buy back much of the stock. This allows a few early investors to earn a profit, giving the stock more legitimacy.
Here's where the pyramid structure takes over. To ensure that the stock price continues to go up, there need to be more investors. Individual investors begin to pump and dump the company's stock by releasing misleading statements about the stock's success or sending out spam e-mails about the upcoming merger, which may or may not ever happen.
The more investors you can fool into buying the stock, the higher the price and the higher the profits for the early investors.
Eventually, someone investigates the claims behind the stock, its real value is discovered and the stock price plummets. As usual, the last round of investors -- the people at the bottom of the pyramid -- lose the most. [source: Pyramid Scheme Alert]

How Pyramid Schemes Work: Author’s Note

"Work from home and earn $5,000 a month!" I see signs like this everywhere and have always wondered what kind of scam could be behind it. After researching this article on pyramid schemes, I have a good idea. Pyramid schemes are so successful because they prey on our desire for quick, easy money. In this scam, however, the odds are stacked so definitively against you that's it's almost mathematically impossible to make any cash at all. It's sad to think of all the people who bought a starter kit with dreams of lucrative sales and a bright future managing a team of salespeople, all from the comfort of home. In situations like this, it's best to heed some sage advice: If it seems too good to be true, it probably is.

Sources

Amway. "Business Opportunity or Pyramid Scheme?" http://www.amway.com/en/BusOpp/business-opportunity-or-pyramid-scheme- 10082.aspx
Federal Trade Commission. FTC Consumer Alert: The Bottom Line About MLM Plans http://www.ftc.gov/bcp/conline/pubs/alerts/pyrdalrt.shtm
Haekal, Reem. "What is a Pyramid Scheme?" Investopedia. http://www.investopedia.com/articles/04/042104.asp
New York State Office of the Attorney General. "Affinity Fraud." http://www.oag.state.ny.us/investors/affinity.html
The New York Times. "Made Millions by Trick in Exchange." July 27, 1920. http://query.nytimes.com/mem/archive-free/pdf?res=9802E6DB1E30E 633A25754C2A9619C946195D6CF
Pyramid Scheme Alert. "Missouri Attorney General Sues "Original Dinner Party" Scheme Perpetrators." http://www.pyramidschemealert.org/PSAMain/pyramids/dinner.html
Pyramid Scheme Alert. "New Wrapping for Old 'Gift'" http://www.pyramidschemealert.org/PSAMain/pyramids/newwrap.html
Pyramid Scheme Alert. "The Penny-Stock Pyramid Scheme (and Its Similarity to Multi-level Marketing Pyramids)." http://www.pyramidschemealert.org/PSAMain/pyramids/investscheme.html
Taylor, John M. Consumer Awareness Institute. "Which Does the Greater Harm?" http://www.mlm-thetruth.com/AveMLMvsNPSvsVegasvsDirSales6-6.pdf

Pyramid Schemes: Cheat Sheet

Stuff you need to know:

A pyramid scheme is any "business opportunity" in which the only real way to make money is to recruit more salespeople.
If recruiting new salespeople is the only way to make money, then those who get into the game late will never be able to find enough new recruits to recoup their money. In fact, the success of the top few levels of the pyramid requires that many people below them lose their money.
In a product-based pyramid scheme, 99.88 percent of participants never make any money. In any pyramid scheme, it's a mathematical fact that 88 percent of participants will be on the bottom level.
Multi-level marketing companies like Amway or Avon are different than pyramid schemes because participants can only make money by selling products or managing a team of salespeople (from which they get a percentage of their sales). No money is paid simply for recruiting new salespeople and participants aren't required to buy an expensive starter kit or purchase a minimum amount of supplies each month.

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How Pyramid Schemes Work

What is a Pyramid Scheme?

Multi-Level Marketing and Pyramid Schemes

Famous Pyramid Schemes

How Pyramid Schemes Work: Author’s Note

Sources

Pyramid Schemes: Cheat Sheet

Stuff you need to know:

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