Pyramid Scheme Definition
A pyramid scheme is an unsustainable business model where participants profit from recruiting other members. The early participants further recruit new entrants and get a commission to do so. The new entrants pay a fee to join the scheme.
The new entrants further recruit others. This way, a pyramid-shaped hierarchy is formed and hence, the name. The problem is, for the scheme to work, it continuously requires new participants. If recruitment stops, no one gets paid; the pyramid collapses. In many countries, pyramid schemes are illegal.
Table of contents
- Pyramid Scheme Definition
- How does Pyramid Scheme work?
- Pyramid Scheme Example
- Types of Pyramid Scheme
- How to Spot a Pyramid-Scheme?
- Multilevel Marketing vs. Pyramid Scheme
- Frequently Asked Questions (FAQs)
- Recommended Articles
- A pyramid scheme is a channelized system of recruiting members and promising them huge returns if they hire new participants and obtain entrance fees from them.
- In a pyramid scheme the members are pressured to recruit new people rather than sell products or services. The members are rewarded based on hiring ability.
- During a recession, people tend to keep hold of their money; pyramid recruitment comes to a halt. Alternatively, people could start having suspicions about the scheme slowing down recruitment.
How does Pyramid Scheme work?
The founders convince individuals to join their scheme. These participants are responsible for recruiting new members, and each new member pays an entrance fee. This fee goes to the top-level members. This way, the new entrants further recruit participants, forming a pyramid-like structure.
As each member hires participants, they get a commission. There are two possible outcomes for such schemes. Either each person gets a partial investment amount back, or the scheme collapses, and investors suffer losses. In this scheme, money is sometimes used for purchasing products and appointing new members to sell the product by offering them a profit percentage. Money is also used to benefit members by providing loans, purchasing property, and renting properties.
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Video Explanation of Pyramid Schemes
A pyramid scheme has the following characteristics:
- The primary focus is on Recruitment: The focus is on luring more and more members and making them pay the entrance fees.
- Sale of Products is Secondary: Here, there is hardly any focus on the sale of products or services. Most of the time, products serve as a cover for the scam.
- Charges Entrance Fees: This scheme requires joiners to pay an entrance fee, which ultimately goes to the top-level members.
- No Legal Paperwork: Often, these schemes operate illegally; they don’t have any lawful procedure for adding the new members, nor do they provide any valid receipts.
- Assures Impressive Returns is Short Span: These schemes attract their targets by showing them hefty earnings and promising huge profits instantly. Often scammers use forged documents to lure new entrants.
- Not Publicly Listed: Usually, pyramid scheme companies are not listed on any stock exchangesStock ExchangesStock exchange refers to a market that facilitates the buying and selling of listed securities such as public company stocks, exchange-traded funds, debt instruments, options, etc., as per the standard regulations and guidelines—for instance, NYSE and NASDAQ. and therefore have no reliability.
- No Proof of Revenue: Most scheme initiators have no financial statementsFinancial StatementsFinancial statements are written reports prepared by a company's management to present the company's financial affairs over a given period (quarter, six monthly or yearly). These statements, which include the Balance Sheet, Income Statement, Cash Flows, and Shareholders Equity Statement, must be prepared in accordance with prescribed and standardized accounting standards to ensure uniformity in reporting at all levels. to represent their retail sales revenueSales RevenueSales revenue refers to the income generated by any business entity by selling its goods or providing its services during the normal course of its operations. It is reported annually, quarterly or monthly as the case may be in the business entity's income statement/profit & loss account. generated by selling products or services.
Pyramid Scheme Example
Let us further understand the practical application using a hypothetical. Let’s assume Peter starts a pyramid scheme where the cost of being a member is $100 per month. He promises to pay people $90.00 monthly for each recruitment and keeps $10. Paul and George pay Peter directly and join. Therefore, Peter now makes $200 per month. Paul then invites Rachel and Sarah, whereas George invites Bill and Jim. Peter now makes $240 per month, whereas Paul and George make $180 monthly.
However, after paying their $100 fee, the four newest members aren’t making any money. They have to pay $100 monthly if they fail to recruit new members. Bill quits, this means Paul and George won’t make money anymore. If they fail to recruit, they will quit too. Eventually, the pyramid collapses.
Fortune Hi-Tech Marketing
Now, moving on to a real-life case, Fortune Hi-Tech Marketing was once known for selling various products like health, digital TV networks, beauty, cell phone connection, and home security. In 2013, however, the Federal Trade Commission declared it a pyramid scheme. It was found that the sales personnel were rewarded with a fancy commission for recruiting their downline. However, unlike recruitment commissions, sales commissions on products and services were meager. As a result, 100,000 people across the US suffered losses. In addition, the unsuspecting members paid between $100 to $300 in annual fees.
Types of Pyramid Scheme
Some of the common types of pyramid schemes are as follows:
#1 – Multilevel Marketing Plans
Some multilevel marketingMultilevel MarketingMultilevel marketing (MLM) is a form of the business strategy employed by direct sales companies to generate sales revenue. (MLMs) turn out to be pyramid schemes and therefore are termed product-based schemes. Here, the members have to sell the products or services. However, they yield returns by recruiting new participants on top of sales commissions.
#2 – Chain Email
It is operated as a donation fund. Each person who receives an email has to donate some money for a cause to the people mentioned in the list of recipients. Also, they have to forward the message to their contacts by placing their names on top of the recipient list. It is not a legally recognized donation scheme, and at times it is used to deceive people.
#3 – Gifting Clubs
Such schemes often lure new participants by promising them gifts for recruiting new members. The new entrants give gifts to top-level members. The gifts are usually in the form of cash.
#4 – Naked Scheme
In these schemes, profit is earned by appointing new participants; each person recruits some number of participants, and that other person also has to do the same. Eventually, a pyramid hierarchy is formed. In addition, every new member has to pay some joining fees, which is the source of profits.
How to Spot a Pyramid-Scheme?
Investors can safeguard themselves from unsustainable business models by considering the following points.
- Don’t get lured by fancy business models and fat earningsEarningsEarnings are usually defined as the net income of the company obtained after reducing the cost of sales, operating expenses, interest, and taxes from all the sales revenue for a specific time period. In the case of an individual, it comprises wages or salaries or other payments. showcased at conferences and meetings. They are set up to entrap unsuspecting investors.
- Be focused on the product or service offered by such companies or individuals, i.e., investors should know what they are paying for.
- Keep an eye on the product’s actual worth and potential overpricing. Sometimes, customers get lured by seemingly magical offers.
- Research the scheme thoroughly, perform a quick background check of the entity. Investors are recommended to read multiple reviews before transacting.
- Investors should be wary of peer pressure. Be it, friends or relatives, it is recommended to thoroughly research an opportunity before investing.
- Find out if there is a legal agreement for associating with such a scheme or not. If available, investors should go through the forms and documents thoroughly. Even if a proposal seems genuine, the documents can potentially be forged. Investors should expect potential malpractices and look for registrations under a regulatory body. In the absence of association with a regulatory body, investors should avoid particular schemes.
Multilevel Marketing vs. Pyramid Scheme
Multilevel marketing refers to the sale of products through various distributors. The distributors are called sales agents, focusing on product and sales. Multilevel marketing is initiated by genuine companies with the intention of fair-trade practices.
Multilevel marketing aims to reach a maximum number of customers and sell products. Despite networking, the profit entirely comes from product sales. In contrast, pyramid-schemes focus on recruitment. Unlike multilevel marketing, a pyramid scheme profits from the entry fees.
Frequently Asked Questions (FAQs)
It is illegal only in some countries. Pyramid schemes are illegal in the United States, the United Kingdom, France, Canada, Malaysia, Norway, Australia, New Zealand, Nepal, Sri Lanka, and Iran. Nonetheless, it is strongly recommended not to invest in such a plan as it follows a highly unsustainable business model.
A pyramid scheme is usually a scam initiated by a single person who recruits a few people and makes them add new participants to form a chain of members. But eventually, this whole system collapses, and the organizer flees with all the money collected by their networks. If the initiator is proven guilty, the court can recover some amount through legal proceedings. The court seizes the fraudster’s assets.
A scam related to the pyramid scheme can be locally reported at the district’s consumer protection division. For instance, in the US, such a crime can be reported to the Federal Trade Commission (FTC).
This has been a guide to what is the Pyramid Scheme and its definition. Here we discuss features of pyramid schemes and types with an example and features. You may learn more about financing from the following articles –