What is Pyramid Scheme?
Pyramid Scheme is an investment scheme in which participants make the profit by recruiting other members under them and each participant has to recruit new participants where each new entrant has to pay the entrance fees for entering into the scheme and this makes the hierarchy of the persons.
How Does Pyramid Schemes Work?
- Some top-level persons start the scheme by depositing entrance fees they are responsible for recruiting new members each member has to pay the entrance fees and the top-level persons will get some percentage of entrance fees of the number of members appointed by it.
- This way each member recruits other new members and shares what they get by recruiting new members is profit from investing in the scheme. There are two options at the end either each person gets the full or partial investment amount back or scheme will collapse and investors suffer loss.
- In this scheme, money is sometimes used for purchasing the products and appoint new members to sell the product by offering them a percentage of profit and it can also be used for the benefit of members like giving the loan to members, purchasing property by members, and giving it on rent, etc.
Example of Pyramid Scheme
- Mr. X’s top-level person decided to start to collect money by a pyramid scheme. He approached some of his contacts to enter into the scheme by paying membership fees of $ 100 and in return they get the free food coupons of his hotel and also he ask them to approach other persons to enter into the scheme by paying entrance fees and they get 10% of entrance fees as commission so he gave each of three to get 10 new entrants so the new entries become 10 * 10 * 3 = 300 persons.
- And these 300 persons have to appoint 10 people each total member become 300 * 10 = 3,000 members and he got the collection as 3000 * 100 = $300,000 And he distributed free coupons of $. 50 to each member and percentage of entrance fees 3000 * 100 * 10% = $30,000 so in all Mr. X earned $ 120,000 (300,000 – 150,000 – 30,000) as profit.
Types of Pyramid Scheme
- Multi-Level Marketing Scheme: In a multi-level pyramid, scheme products are marketed and sold by recruiting new participants.
- Chain Email: It is used for donations each person you approach has to donate some money to the scheme so as poor will get the benefit from donations. It is not legally recognized donation schemes. Sometimes this scheme is used to fraud the persons.
- Product-Based Scheme: In product-based schemes, participants are used as sales agents and in return they get some percentage on the sale price or some fixed amount on each sale.
- Naked Scheme: In these schemes, profit is earned by appointing new participants each person recruit some number of participants and that other person also have to do the same and in this way, pyramid generates.
Why do People are Investing in Pyramid Schemes?
- For Earning good returns on investment.
- For helping the needy persons by collecting huge amounts by way of donations.
- For promoting their products and investment schemes.
- For achieving the sales targets.
- For marketing their product at a low cost than advertising.
- For dividing the work through team building and optimum utilization of manpower.
Pyramid Scheme vs Multilevel Marketing
- Multilevel marketing refers to the sale of products through various distributors. In multilevel marketing, the product is directly sent to customers but through the distributor. The distributors are called sales agents and the focus is on product selling. In a pyramid scheme, the aim is to earn profit by appointing new participants.
- The main focus is on recruiting new participants. This concept can be used for multilevel marketing for selling of products. For multilevel marketing product or service is a must and for pyramid schemes, entrance fees and recruiting new participants is a must.
Some of the benefits are as follows:
- High sales targets can be easily achieved.
- Helpful for large donations and financial support by minimum contribution by each member.
- Highly profitable.
- Lower cost.
- Teamwork can be proved beneficial and efficient.
- Highly effective for startups and product development.
Some of the limitations are as follows:
- High risk of losing investment.
- Termed as illegal in some countries.
- High risk of fraud.
- Difficult to track the mastermind behind the scheme.
- Loopholes cannot be identified.
- Pyramid schemes are the scheme through which each person will get the contribution by recruiting the new members. There are two basic types – product-based and naked schemes.
- A product-based scheme is also called as multilevel marketing product that is marketed through appointing new participants who act as sales agents and to get a commission in return and naked schemes aimed at earning profits by recruiting new members and ask them to pay the entrance fees.
This has been a guide to what is the Pyramid Scheme and its definition. Here we discuss how does pyramid schemes work with an example, types and, differences. You may learn more about financing from the following articles –