A pyramid scheme is an unsustainable business model used by fraudsters to lure participants with promises of quick, high returns in a short period of time. It starts with a few original, top-level members or participants recruiting new members who pay them upfront costs and fees to take part in the business.
Those new members in turn recruit more new members. They themselves receive fees paid by this next level of participants. However, a portion of these subsequent fees is sent up the chain to the original members. The recruitment, payment, and funneling of fees up through various levels of the pyramid continue until no one is left to recruit. At that point, a pyramid scheme collapses for lack of money taken in. Most people involved lose their money.
Often called pyramid scams, these operations are illegal in the U.S.
How Pyramid Schemes Work
Pyramid schemes get their name from the organizational layout of the company. An individual creates the scheme and recruits people to work for them. Each of those people will recruit other people to work under them, resulting in a larger number of people in the next level of the business. At each level, the people continue to recruit other people to work under them, making the pyramid shape wider still.
Amway was investigated by the Federal Trade Commission (FTC) in the late 1970s for being a pyramid scheme. The FTC found that Amway was not a pyramid scheme, and the case is instructive for anyone who wants to get involved in multi-level or network marketing so that you can recognize if any company you are thinking of joining is a pyramid scheme.
The business model in a pyramid scheme is based on paying people to recruit others to the business. Generally, a business based on a pyramid scheme will require a payment to join the business. Then it will promise payments to sales associates for recruiting new members to the operation. The upline gets a share of the payments, so the directors of the company typically enjoy high passive incomes. One thing often missing from such schemes is a legitimate product with value to sell to the public.
When pyramid schemes involve a product, they often require members to buy large quantities of the products which turn out to be very hard if not impossible to sell. Pyramid schemes also don’t require members to have retail sales; instead, they focus solely on recruiting new members to the scheme.
In a real MLM company, while upline members get payments from sales made by the downline, they are not getting paid to recruit new people.
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
Multi-level marketing (MLM) is a legitimate business program. It can, however, become a pyramid scheme if participants are only compensated for recruiting instead of selling. Pyramid schemes only benefit those at the top, those who promise high returns in exchange for their recruits’ investment.
How are pyramid schemes distinguished from real multilevel marketing businesses? It can be distilled down to one concept: a legit MLM business has two revenue streams. A real MLM company sells a legitimate, useful product to the public as well as recruits new members to build your downline (downline are the sales associates you recruit, you get a cut of their sales).
Often, consumers are unable to distinguish between an illegal pyramid scheme and a legitimate MLM opportunity. Regulators and industry continue to debate where the legal lines should be drawn. Multi-level marketing uses a network of independent representatives to sell consumer products in a lawful and legitimate manner. The primary basis for compensation must be the sale of products and services to the end user.
A pyramid scheme sells products to consumers to make it appear as if they are a multi-level marketing company. Despite this, little or no effort is made to market the product. Instead, money is made by recruiting others to market the program. When new “distributors” sign up, they are sometimes encouraged to purchase inventory or overpriced products/services.
The majority of profits made by pyramid companies come from recruiting new members and disguising entry fees as mandatory purchases of training, computer services, or product inventory.
The simplest pyramid scheme is the chain letter, in which the recipient pays $1.00 or more to each of five names on a list, copies the letter, and then sends it to new recipients with the recipient’s name included. There are many chain letters that claim to be legitimate because they offer a product. The product is just a pretense when examined closely.
There are times when the newsletter is the only item new members purchase and describes additional “get rich quick” schemes. Alternatively, the newsletter may be offered for free with every new membership. Either way, the scheme is merely a pyramid if distributors are paid to recruit new members rather than sell a real product.
Ponzi schemes are investment scams that rob Peter to pay Paul. Unlike pyramid schemes, they do not necessarily follow a hierarchical structure, but existing investors can expect high returns.
There is usually only one investment made by investors in a Ponzi scheme. Then, investors wait for their money to be returned. The leader of the scheme persuades other investors to take part by providing them with new money. Ponzi scheme participants usually lose everything when the money for these schemes runs out.
The notorious Ponzi scheme artist Bernard Madoff was sentenced to 150 years in prison for operating a multibillion-dollar Ponzi scheme.
Investing with Madoff led to many high-profile individuals becoming involved, and he falsified portfolios and relevant paperwork in order to pay off early investors. All of their money was lost by most investors. On April 14, 2021, Madoff passed away in prison.
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
The viability of pyramid schemes depends on the number of new, paying participants. There must be continued growth at the base of the pyramid. The entire structure collapses when there are no willing and available participants.
Pyramid schemes cannot last for a long time. People will always lose money. Due to delays in payments from lower-level recruits, even high-level early participants may lose money near the end of the campaign.
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.
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.