What Is a Pyramid Scheme?

A pyramid scheme is a deceptive business concept used by con artists to entice participants with promises of quick, large returns in a short period of time. It all begins with a few original, top-level members or participants recruiting new members who pay up front costs and fees to participate in the business.

Those new members then bring in more new members. They receive fees paid for by the following level of participants. However, a portion of the subsequent fees are distributed to the original members. The process of recruiting, paying, and funneling payments up through the pyramid continues until no one is left to recruit. At that point, a pyramid scheme fails due to a shortage of funds. The majority of those involved lose money.

These enterprises, known as pyramid schemes, are prohibited in the United States.

How Pyramid Schemes Work

Pyramid schemes acquire their name from the company’s hierarchical structure. The program is created by an individual who recruits people to work for them. Each of those individuals will hire others to work for them, resulting in a larger number of people at the next level of the organization. People continue to recruit others to work beneath them at each level, expanding the pyramid shape even further.

In the late 1970s, the Federal Trade Commission (FTC) investigated Amway for operating a pyramid scheme. The FTC determined that Amway was not a pyramid scam, and the case is instructive for anybody interested in multi-level or network marketing to recognize if any organization you are considering joining is a pyramid scheme.

A pyramid scheme’s business concept is focused on paying people to attract others into the firm. In general, a pyramid scheme-based business will require a charge to join. Then it will promise to pay sales staff for bringing in new members to the operation. Because the upline receives a portion of the payments, the company’s directors generally have significant passive incomes. One item that is frequently missing from such schemes is a real product with monetary worth to offer to the general public.

When pyramid schemes incorporate a product, members are frequently required to purchase enormous quantities of the product, which turns out to be extremely difficult, if not impossible, to sell. Pyramid systems do not also require participants to have retail sales; instead, they are primarily focused on recruiting new members to the plan.

In a genuine MLM organization, while upline members are compensated for downline sales, they are not compensated for recruiting new members.

The FTC decided that Amway was not a pyramid scheme. Among the reasons given were:

  • Amway does not pay distributors to recruit new members.
  • Amway requires distributors to maintain a minimum level of retail sales.
  • Amway does not require distributors to purchase large stocks of inventory.
  • Members must accept returns of excess inventory from downline sellers.

The main things to keep in mind are whether or not the company requires you to pay to join, if you will get paid to recruit others, and most of all whether or not the company has a legitimate product that sells. If a company strikes out on all three of these items, it’s a good idea to look elsewhere.

Types of Pyramid Schemes

Multi-Level Marketing Pyramid Scheme

MLM (multi-level marketing) is a legitimate business opportunity. However, it can devolve into a pyramid scheme if players are only reimbursed for recruiting rather than selling. Pyramid systems benefit only those at the top, those who promise big returns in exchange for the investment of their recruits.

What distinguishes pyramid schemes from legitimate multilevel marketing businesses? It boils down to this: a legitimate MLM firm has two revenue streams. A genuine MLM organization sells a valid, useful commodity to the general public while also recruiting new members to develop your downline (downline are the sales associates you recruit, you get a cut of their sales).

Consumers are frequently unable to tell the difference between an illegal pyramid scheme and a legitimate MLM opportunity. Regulators and industry are still arguing about where the legal lines should be established. Multi-level marketing use a network of independent agents to legally and legitimately sell consumer products. The sale of items and services to the end user must be the fundamental foundation for compensation.

A pyramid scam offers products to customers in order to appear to be a multi-level marketing organization. Regardless, there is little or no effort made to sell the goods. Instead, money is made by enlisting the help of others to sell the program. When new “distributors” sign up, they may be urged to buy inventory or overpriced products/services.

Pyramid companies make the majority of their money by recruiting new members and disguising admission fees as required purchases of training, computer services, or product inventory.

Chain Letters

The chain letter is the most basic pyramid scam, in which the recipient pays $1.00 or more to each of five people on a list, copies the letter, and then sends it to new recipients, including the recipient’s name. Many chain letters pretend to be reputable because they provide a product. When inspected closely, the product reveals itself to be a ruse.

At times, the newsletter is the only item purchased by new members and describes further “get rich quick” schemes. Alternatively, the newsletter could be provided free of charge with each new subscription. If distributors are paid to recruit new members rather than offer a legitimate product, the program is just a pyramid scheme.

Ponzi Schemes

Ponzi schemes are investment schemes in which Peter is robbed to pay Paul. They do not necessarily follow a hierarchical structure, unlike pyramid schemes, although existing investors can expect substantial profits.

Investors in a Ponzi scheme often make only one investment. Then, investors await the return of their funds. The scheme’s leader persuades other investors to join by giving them with new funds. When the money for these scams runs out, the participants frequently lose everything.

Bernard Madoff, the legendary Ponzi scheme artist, was sentenced to 150 years in prison for running a multibillion-dollar Ponzi scheme.

Investing with Madoff attracted many high-profile individuals, and he fabricated portfolios and relevant papers to pay off early investors. Most investors lost their entire investment. Madoff died in prison on April 14, 2021.

Example of a Pyramid Scheme

Big Co-op Inc. is an example of a product-based pyramid scheme.

Big Co-op Inc.’s owners were convicted of operating a pyramid scheme in California in April 2010. As part of this scheme, participants purchased a “license,” which entitled them to commissions on sales of Big Co-op products. The company claimed that its profits were generated from the sale of its products, not from the sale of licenses to new participants. 

However, the company made almost all of its profits by selling licenses and by collecting monthly dues from its clients. Over 1,000 Californians were scammed out of $8.2 million, and each founder faces up to 20 years in prison.

How Pyramid Schemes Fail

Pyramid schemes’ viability is determined by the number of new, paying participants. The bottom of the pyramid must continue to grow. When there are no willing and available participants, the entire structure collapses.

Pyramid schemes cannot last forever. People are always going to lose money. Due to payment delays from lower-level recruits, even high-level early participants may lose money near the campaign’s end.

Is a Pyramid Scheme Illegal in the United States?

Basically, yes. In the U.S., recruiting anyone to participate in a pyramid scheme is a felony. An individual may be sentenced to four years in prison and fined $5,000 for this crime.

Can You Make Money From Pyramid Schemes?

Pyramid schemes are usually profitable only for founders and early members. They entice new, fee-paying members with promises of quick and large profits. Further fee-paying members are recruited by these members. The cycle continues. Founders and early members receive the income. Once there are no more fee-paying members to support the existing members, the scheme collapses.

Are Pyramid Schemes the Same as Multi-Level Marketing Programs?

While some unethical pyramid schemes try to pass themselves off as multi-level marketing firms, the reality is that a legitimate multi-level marketing company is not a pyramid scheme. Real multi-level marketing businesses sell legitimate products to real customers and are not simply about endless recruiting of members.

In a pyramid scheme, there is no product or service. The investment you make goes into the scheme itself. This means that the entire business runs on money simply moving from one person to another. Therefore if anyone profits from the scheme, someone else has to lose out.

Final Words

Many countries prohibit pyramid schemes. In a pyramid business model, members recruit their family, friends, and acquaintances in order to profit from their network of contacts. Ultimately, this can strain relationships. Investors should stay away from such schemes. 

If you join a pyramid scheme disguised as a multi-level marketing program, your decision will affect not only you but also everyone you bring into the program.

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