A pyramid scheme is a business model where individuals invest in a business with the promise of being paid once they recruit other members into the scheme. Such a scheme may appear to offer goods and services but in reality, the investor’s income is based on how many members they recruit.
How it works
A pyramid scheme, as the name suggests, is structured like a pyramid with one person on top at the apex and many people at the bottom. It usually begins with a person or group of people recruiting new members into an organization with the lure of paying them once they recruit new members. Individuals are required to pay a certain amount in order to join the “business”.
A share of this payment goes to the recruiter, and thus it is in the interest of every member to recruit as many people as they can.
Pyramid schemes rarely involve sales of products or services of real value. As such, the only source of revenue for the scheme is money brought in by new recruits or it’s existing members.
As new members join the scheme, the level of the pyramid becomes larger and larger and so does the amount of money that is needed to sustain it.
In order to ensure that there is enough money to pay everyone who joins, the scheme would have to expand indefinitely. But this is impossible since there is only a finite number of people in the universe. At a certain point in time, such a scheme is bound to run out of recruits and when this happens the pyramid scheme collapses since it cannot raise enough revenue to pay its members.
The end result? The masterminds run into hiding and a lot of people lose their money.
In pyramid schemes, people at the top of the pyramid (those who were first to join) together with the masterminds, profit at the expense of those at the bottom (those who join in the middle to late stages of the scheme).
At any given point in time, the people at the bottom are more than those at the top and as such, the majority of people who join a pyramid scheme are bound to end up as losers.
Are pyramid schemes legal?
Pyramid schemes are illegal in the US and in many other parts of the world. Many individuals have been prosecuted for running such schemes.
For example in 2007, Harvey Dockstader Jr was sentenced to two years in prison for running Elite Activity, a scheme where people were asked to contribute an initial monetary gift and promised huge profits once they recruited new members. In April the same year, SEC froze the assets of Wealth Pools International because of operating a pyramid scheme.
Telltale signs of a pyramid scheme
Pyramid schemes usually come disguised in the form of various investment opportunities. Sometimes these opportunities may seem reasonable and even legitimate. That is why it is important to learn to spot the difference between a pyramid scheme and a legitimate business opportunity.
Some of the characteristics of pyramid schemes include:
- No genuine products
The organization does not sell any product or services to generate revenue, and if it does, they are of little to no value.
- Membership fee
More often than not, a pyramid scheme compels members to pay an enrollment fee and/or buy products they don’t even need.
- Emphasis on recruiting new members
Pyramid schemes pay more emphasis on recruitment of new members than on the sales of products or services. Thus, you are required to recruit new members in order to make money.
- The promise of “Easy money”
One of the tactics that pyramid schemes use to lure in new members is the promise of earning a lot of money in a short period of time.
Ponzi schemes are named after the Italian swindler Charles Ponzi who gained notoriety in the 1920’s for his fraudulent activities which cost investors over $20 million.
Ponzi claimed that he could generate a 50% return for investors within 45 days and a 100% return within 90 days by arbitraging postal reply coupons.
In reality, he was taking money from new investors and using it to pay earlier investors.
People often confuse Ponzi schemes with pyramid schemes and use the two words interchangeably. However, while both are forms of financial fraud involving the use of new investor’s funds to pay earlier investors, there is a distinguishing characteristic between the two: A pyramid scheme is based on the concept of network marketing and is hierarchical, while a Ponzi scheme is not.
Multi-Level Marketing (MLM)
Multi-Level Marketing is a strategy employed by direct sales companies to encourage their distributors to recruit additional distributors by paying them a commission on their recruit’s sales. In multi-level marketing, distributors make money through direct sales to clients as well as through commissions on sales by members in their downline.
Multi-Level Marketing is a legitimate business opportunity but is usually marred by controversy, especially due to the existence of pyramid schemes which are usually presented as MLMs.
An important factor in determining the legitimacy of an MLM company is whether the company emphasizes on the sales aspect as opposed to the recruitment of new members. If the company pays more attention to recruitment of new members then it is most likely a pyramid scheme.
However, the company was able to prove that it was not operating a pyramid scheme by showing that most of its revenue comes from product sales, not recruitment.
There is a very thin line right there, believe me. There are many people out there who have been seduced to buy thousands of dollars worth of products, only for them to realize that you just can’t re-sell them to anyone you meet.
Let’s face it, If you are in any MLM, you are in the recruiting business. Nobody makes money out of such businesses by reselling the products.
So there you have it. What is the definition of a pyramid scheme? This is it. Pyramid schemes may seem lucrative with promises to help you make quick money, but they are very risky. Majority of the participant’s in pyramid schemes are destined to lose their money since such a system is not sustainable in the long run.
Given that pyramid schemes are often disguised as legitimate business opportunities such as multi-level marketing, it is important to learn to distinguish between the two. While both share a few similar characteristics, Multi-Level Marketing is different in the sense that it is legitimate and involves the sale of genuine products and services. Unfortunately, in this day and age, you just have to work a little harder to convince folks that you are not involved in some scheme.
There are many ways one can make money legitimately.
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Many thanks for reading my post. If you have a question or comment regarding pyramid schemes, please leave it below. I would love to hear from you.
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