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What is a 'Pyramid Scheme'

A pyramid scheme is an illegal investment scam based on a hierarchical setup. New recruits make up the base of the pyramid and provide the funding, or so-called returns, the earlier investors/recruits above them receive. A pyramid scheme does not involve the selling of products. Rather, it relies on the constant inflow of money from additional investors that works its way to the top of the pyramid.

BREAKING DOWN 'Pyramid Scheme'

An individual or a company initiates a pyramid scheme by recruiting investors with an offer of guaranteed high returns. As the scheme begins, the earliest investors do receive a high rate of return, but these gains are paid for by new recruits and are not a return on any real investment. From the moment the scam is initiated, a pyramid scheme's liabilities begin to exceed its assets. The only way it can generate wealth is by promising extraordinary returns to new recruits; the only way these returns receive payment is by getting additional investors. Invariably these schemes lose steam and the pyramid collapses.

Basic Pyramid Scheme

A pyramid scheme is a variation of the Ponzi scheme, which offers a promise of high investment returns that are not available from traditional types of investment. In practice, the structure of pyramid schemes induces others to recruit victims and collect money that eventually makes its way to the top of the pyramid. In a typical setup, one person recruits a second person to invest a certain amount of money. The second person recovers his investment by recruiting people under him to invest in the scheme. The more people he can recruit under him, the greater his profit and a certain percentage of the profits of all recruiters work their way up the pyramid to enrich the recruiters before him. Each person must recruit a certain number of people. The process continues until there are fewer people at the bottom of pyramid, and it collapses under its own weight. Generally, only the people near the top of the pyramid make any significant profits, and people near the bottom never recover their investments.

Business Pyramids

On their face, multi-level marketing companies are structured like a pyramid. Individuals have the opportunity to invest in their own businesses, which, ostensibly, distribute a product. However, with some companies, the real profit opportunity comes not from selling products but from inducing others into buying into their own business, with a percentage of the investment moving up the hierarchy of recruiters. Among the more high-profile multi-level marketing companies to be investigated as a pyramid scheme is Herbalife Ltd. Herbalife distributors can make money just by selling the company’s products, but they must purchase and sell thousands of dollars' worth of the products before they realize a profit. Critics allege that the company's top recruiters receive the vast majority of profits.

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