How Pyramid Schemes Work

By: Dave Roos

Famous Pyramid Schemes

Millionaire Charles Ponzi poses for pictures in his pajamas in 1942.
Hart Preston/Time Life Pictures/Getty Images

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:

  1. The perpetrators of the scam create a shell company without any assets or organizational structure, just a name and a stock symbol.
  2. 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.
  3. 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).
  4. Even at only a penny a share, stockholders are grossly overpaying since the company has no real value.
  5. 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.
  6. 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.
  7. The more investors you can fool into buying the stock, the higher the price and the higher the profits for the early investors.
  8. 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]