A pyramid scheme is an unsustainable business model that works by recruiting an increasing number of members at different levels. Instead of supplying any tangible, for-value goods or services, the model banks on promises of profits for enrolling other members into the scheme. These recruits are required to pay an upfront cost, and this cost makes for the promised payments. Also called as pyramid scams, these schemes aren’t able to sustain for long and are considered illegal in many countries.
How Pyramid Schemes Work?
Think about a pyramid structure which starts at the top as a single point and expands wider as we move down to different levels. A two-dimensional representation of such a pyramid structure is as follows.
Assume that the single person at the top - the initial recruiter represented by the number 1 - starts a recruitment scheme. He recruits 10 people at his next level, each of whom is required to “invest” a certain amount of money to become a part of and benefit from the scheme. This money goes to the initial recruiter. Apart from investing the money, these 10 members at the second level are required to recruit more members who form the next level. For each new member they recruit, a certain amount of payment is promised which comes from the share of the money taken from every additional member they recruit. The newly recruited members at the third level are also required to make similar investment and are tasked to recruit more members in a similar manner. Each of those new recruits is also obligated to pay their investment to the person who recruited them. Recruiters get a profit of all of the money received, minus their initial investment paid to the person who recruited them. Eventually, a big multi-level structure comes into existence with each level having exponentially higher number of members.
However, since profitable opportunities don’t really exist and the number of recruits draws to a close, the process continues only until the base of the pyramid is no longer strong enough to support the upper structure, and there are no more recruits.
Types of Pyramid Schemes
Different forms of pyramid schemes exist which can be broadly classified as follows:
Multi-Level Marketing (MLM) Pyramid Scheme
Multi-level marketing (MLM) is a legal business practice though it involves recruitment to sell a product or service that actually has some inherent value. A recruit can profit by selling a product or a service, and is not necessarily mandated to recruit more salespeople below them, though they can do so if they wish. A key difference between multi-level marketing and pyramid scheme is that the former provides an actual product or service whereas the latter doesn't and only channels the money to upper levels as sourced through recruitment.
However, a variant of MLM exists as a MLM pyramid scheme, which most likely force sells a product that has no real value. It could involve sale of printed material like reports or courses on investment or healthcare. Such schemes work and remain alive by forcing the recruits to buy such no-value products at high costs, and these recruits are mandated to sell them to their next level to recover their money and any surplus profits.
Chain emails work by asking the recipient to donate a certain amount of money to a list of people. After making the donation, the donor qualifies to delete the name of the first person on the list they received, add their own name, and forward the chain to their own contacts. They then hope that one or more recipients of their forwarded mail will donate money to them (and others on the list), plus the chain mail forwarding will keep them in the list for long to continue receiving multiple such donations till their name gets deleted.
Many pyramid schemes adopt the guise of gift-giving or loans that take place in investment clubs. They work by following the mechanism of donating a gift to the recruiter, and then recruit more people into the club in order to receive a gift from them (return on investment). These kinds of pyramid schemes that work in disguise of club programs or gift are also considered illegal.
Ponzi schemes are fraudulent investment plans which work on the principle of “Rob Peter to pay Paul.” They may not necessarily follow a hierarchical structure like that of a pyramid scheme which makes it a grey area to include them as a pyramid scheme. However, they work on promising high returns to the old investors by taking investment money from new investors which essentially results in establishing a chain scheme, and fit in the working of pyramid scheme where early adopters stand a chance to benefit at the expense of the late entrants. People are often lured into these schemes by promises of high returns that are too good to be true, and they end up losing their hard earned money. (See also, What is the difference between a Ponzi and a pyramid scheme?)
Example of Pyramid Scheme
During the 2008 recession period, a scheme was launched in Canada that promised citizens an opportunity to make up to $100,000 by selling “low-cost” travel club membership plans. However, to qualify, the applicant “seller” was first required to purchase the travel club membership for themselves by paying $3,200. The applicants were promised to be paid $5,000 for each similar membership they sold. The payments can be realized when the applicant member accumulates $100,000 which was possible only when they sold at least 20 such membership plans.
While more than 2,000 citizens opted for the scheme by paying the membership fee, they never got their promised returns because selling such high number of packages was impossible for the masses. The long running recession that followed the 2008 crisis made things further difficult as people avoided spending on travel and luxury. Though the scheme was disguised to sell a product, it was essentially designed to make money on the chain through different levels. A class action lawsuit filed by the aggrieved investors helped return their invested money, and forced the closure of the pyramid scheme.
How the Pyramid Tumbles?
The pyramid remains stable as long as the lowest level remains bigger and wider than the upper levels. Once the lowest level trims, the whole structure collapses.
People are deceived into believing that by giving money into such schemes, they will make more money. However, the scheme simply banks on getting more and more contributions from an increasing number of people at the bottom levels. In reality, no wealth ever gets created, no product gets sold, no service is offered and no investment is made that can generate returns or any tangible output.
Such schemes, though appear lucrative, cannot go on forever. The biggest issue with the operating model of such schemes is that the money moves from bottom to top. The limited number of members at the top levels hope to benefit from the contributions made by the larger number of people at the lower levels. Even if all the people in the country join the scheme, it will eventually saturate the contributions once the lowest level becomes smaller than the upper ones.
Since it is impossible for the cycle to sustain itself, people will lose their money somewhere down the line. Early adopters, like those at level 2 or level 3, may still have chance to recover their invested money, only if they are paid back. Those early birds may still lose their initial payments as the dodgy scheme may put forth conditions that delay their payments - like payment to be made only after X levels are filled, or a waiting period of Y months after hitting a particular payment threshold. Those who are towards the bottom of the pyramid are the most vulnerable lot, as it becomes increasingly difficult to recruit the number of people required to pay off the previous layer of recruiters. The increasing popularity of scheme leads to its destruction as the word gets out and people never get their payments.
The Bottom Line
Pyramid schemes have existed for long in different forms, and are often considered illegal across the different jurisdictions of the world. While one can identify a pyramid scheme based on how they promise to work, participating in them involves deception and fraud because not everyone will receive the money promised in return. They bank on using the network effect, where trapped individuals end up recruiting their own acquaintances as there is the trust element among the engaging parties. One should exercise caution before getting into such schemes and closely look at the working model, intended use of invested money, and how returns are expected to be generated. (See also, Investment Scams: Different Types Of Scams.)