Photo courtesy of Great Beyond via Flickr.
Pyramid schemes: you don’t always know them when you see them, because they’re decorated with petals and promises, tied with a bow, and passed off as legitimate businesses.
Here’s a quick guide to how pyramid schemes work — or more accurately, how they don’t — and how to spot them.
First things first: What is it?
The classic pyramid scheme, according to the SEC, is a business model under which participants attempt to make money solely by recruiting new members to work beneath them, and accrue money every time another member is recruited.
Typically, members must make an up-front payment to join, and from there can turn a profit by automatically earning a share of the payments from each person they recruit. The system funnels money to the top is it grows, and because profit comes from enrollment fees rather than the sale of a product or service, it’s ultimately unsustainable.
As the picture below depicts, the more levels a pyramid scheme has, the less sustainable it becomes.90 percent or more — of people involved in pyramid schemes will lose their money. Money invested becomes all but impossible to get back, let alone profit from, the closer you are to the bottom of the pyramid.
In other words, only the first people to get into the scheme — about 10 percent of those involved — won’t lose money. Odds are not in favor of the many participants beneath them.
Add that to the fact that pyramid schemes are illegal in the United States and 39 other countries, and you’ll have a stronger grasp at just how shaky the concept can be.
Types of Pyramid Schemes
Pyramid schemes come in multiple shapes and sizes. Here are some notable variations:
- The Eight Ball Model: Each member can recruit just two beneath them, for a total of 15 people in four tiers. Also known as the “Airplane Game,” “Original Dinner Party,” or “Treasure Traders,” tiers are labeled thematically to denote participants’ levels.
When a certain sum of money reaches the top, the “captain” leaves, each person advances up a level, and the model break into two new models/games. Mathematically speaking, 88 percent of participants will lose money.
- Matrix scheme: Also known as a matrix sale, site, hellavator, escavator, or ladder scheme, this model works when people purchase an item of marginal value in order to be put on a waiting list for a prize.When new members join the scheme, the original participants move up one level closer to their prize. Because only one reward is issued for every 10 members that join, 90 percent of those in line won’t get theirs.
- Multi-level Marketing: Also known as MLM or network marketing, this type of business model is in essence a legal pyramid scheme that uses the sale of a product or service to mask its pyramid structure.Also known as pyramid selling, MLM can collapse for the same reasons a scheme can.Some MLM businesses may be legitimate, but only if money is made from on sales to the public instead of sales to recruits.
- Franchise Fraud: A type of pyramid scheme that offers individuals a portion of a franchise’s business valuation, in return for marketing more franchises to others instead of actual product sale.
- Ponzi Schemes: Early investors in a business or product are paid dividends out of the money put in by newer investors to create the false appearance that investors are profiting from a legitimate business.
- Chain letter: Letters that ask recipients to donate a small amount of money to a list of people, then take off the first name and add theirs to the bottom. By forwarding said letter, participants are asking others to give money for the promise of making money — a clear indication of a scam.
How to spot a Pyramid Scheme
How do you know if something is a scam? Usually if it offers monetary reward for recruitment but doesn’t require any actual sale, or entails the sale of a dubious product but depends on enrollment for profit, it’s a scheme of some sort.
When in doubt, The Federal Trade Commission has an in depth guide for testing the legitimacy of an alleged multi-level marketing plan. Their main points are:
- Consider the product: Is it safe, quality, and priced competitively?
- Learn more about the company: Dig deep and research its track record, reputation, and history
- Evaluate the plan: Ask about compensation structure, potential expenses, support for claims, and get the answers in writing
- Ask Questions: Dig for details on refunds, expenses, company profits, and more. If distributors sell more product to other distributors than to the public or make more money from recruiting than they do from selling, it’s probably a pyramid scheme.