Pyramid Scheme

Updated on April 12, 2024
Article byWallstreetmojo Team
Edited byWallstreetmojo Team
Reviewed byDheeraj Vaidya, CFA, FRM

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.

Key Takeaways

  • 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

 

Features

A pyramid scheme has the following characteristics:

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:

Pyramid Scheme

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Source: Pyramid Scheme (wallstreetmojo.com)

#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.read more (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.

  1. 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.read more showcased at conferences and meetings. They are set up to entrap unsuspecting investors.
  2. Be focused on the product or service offered by such companies or individuals, i.e., investors should know what they are paying for.
  3. Keep an eye on the product’s actual worth and potential overpricing. Sometimes, customers get lured by seemingly magical offers.
  4. Research the scheme thoroughly, perform a quick background check of the entity.  Investors are recommended to read multiple reviews before transacting.
  5. Investors should be wary of peer pressure.  Be it, friends or relatives, it is recommended to thoroughly research an opportunity before investing.
  6. 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)

Are pyramid schemes illegal?

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.

Can you get your money back from a pyramid scheme?

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.

Where to report a pyramid scheme?

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).

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