A pyramid scheme is a sketchy and unsustainable business model, where a few top-level members recruit newer members, who pay upfront costs up the chain, to those who enrolled them. As newer members in turn recruit underlings of their own, a portion of the subsequent fees they receive is also kicked up the chain. Often called "pyramid scams," these operations are illegal in some countries.
- The vast majority of pyramid schemes rely on profiting from recruitment fees and seldom involve the sale of actual goods or services with intrinsic value.
- Multi-Level Marketing operations (MLMs) are similar in nature to pyramid schemes but differ in that they involve the sale of tangible goods.
- In 2008, Canada was overtaken by a sweeping pyramid scheme, resulting in a class-action lawsuit against the operation, which was forced to shut down and return funds back to aggrieved members.
How Pyramid Schemes Work
Pyramid schemes are so named because they resemble a pyramid structure, starting with a single point on top, that becomes progressively wider toward the bottom (see diagram below).
Let's assume the following: Founder Mike sits alone at the top of the heap, represented by the number "one." Assume Mike recruits 10 second-tier people to the level directly below him, where each newbie must issue him a cash payment for the privilege of joining. Not only do those buy-in fees funnel directly into Mike's pocket, but each of the 10 new members must then recruit 10 tier-three members of their own (totaling 100), who must pay fees to the tier-two recruiters, who must send a percentage of their takes back up to Mike.
According to the hard-sell pitches made at recruitment events, those bold enough to take the pyramid plunge will theoretically receive substantial cash from the recruits below them. But in practice, the prospective member pools tend to dry up over time. And by the time a pyramid scheme invariably shuts down, the top-level operatives walk away with loads of cash, while the majority of lower-level members leave empty-handed.
It should be noted that because pyramid schemes heavily rely on fees from new recruits, the vast majority do not involve the sale of actual products or services with any intrinsic value.
Types of Pyramid Schemes
Different forms of pyramid schemes exist which can be broadly classified as follows:
Multi-Level Marketing Pyramid Scheme
Multi-level marketing (MLM) is a legal business practice, but unlike traditional pyramid schemes, this model involves the sale of actual goods or services. But participants are not mandated to close any sales, in order to generate income by recruiting members below them.
Some MLMs are nearly indistinguishable from pyramid schemes because they involve the sale of printed materials that have no real value, such as educational courses. These MLM schemes thrive by forcing recruits to buy such no-value products at high costs, and by making them sell these same products to next generational members.
Chain emails persuade naive recipients to donate chunks of money to everyone listed within the email. After making the donations, the donor is invited to delete the first name on the list and replace it with his own, before forwarding the chain along to his own group of contacts, with hopes that one or more of them will send cash his way. In theory, recipients keep collecting donations until their name is deleted from the list.
Ponzi schemes are investment cons which work on the premise of "Robbing Peter to pay Paul." They may not necessarily adopt a pyramid scheme's hierarchical structure, but they do promise high returns to existing investors by taking investment money from new blood. Often lured by the prospect of too-good-to-be-true returns, most Ponzi participants end up losing everything.
Investment advisor Bernard Madoff, arguably the most notorious Ponzi scheme artist, was sentenced to 150 years in prison for operating a multibillion-dollar illegal operation.
An Example of a True Pyramid Scheme
In 2008, a massive pyramid scheme swept through Canada, promising citizens a chance to get rich by selling low-cost travel club membership plans. To qualify, applicant "sellers" were first required to purchase memberships for themselves, at a costly $3,200 price tag. More than 2,000 folks brought out their checkbooks, as they were promised $5,000 for each similar membership they sold. However, profits could only be realized when applicant members accumulated $100,000 in sales, which entailed selling at least 20 membership plans. But this proved virtually impossible in a downward economy, where people fiercely clung to their money. Consequently, aggrieved investors filed a class-action lawsuit, resulting in the return of their money, and the dismantling of the scheme.
How the Pyramid Tumbles
Pyramid schemes are viable as long as the lowest levels remain wider than the upper ones. But once the lowest levels shrink, the entire structure collapses. By nature of exponential math, it's just plain impossible for pyramids to sustain forever, and somewhere in the chain, people will invariably lose their money. Interestingly, even high-level early adopters may lose money near the end, due to conditions that delay their payments from underlings, which often require waiting periods.
The Bottom Line
Pyramid schemes are illegal in many countries. The model of profiting by using the network effect often traps individuals into recruiting their acquaintances, which can feel slimy for everyone involved and can ultimately strain relationships. Investors should exercise caution with such schemes or simply avoid them altogether.