A pyramid scheme is a fraudulent multi-level marketing (MLM) arrangement. Generally, the scheme operates under the guise of selling a product, though the profit from the scheme is based on number of recruits rather than strength of sales. According to the Federal Trade Commission (FTC), pyramid schemes generally operate by investors paying an initial sum to a promoter. The investor is then instructed to recruit a set number of additional investors, who must then also recruit more investors. Investors are told they will be compensated for their recruits, as well as for the recruits of their recruits. This would appear to result in a profit from the initial investment. However, while earlier investors may make a profit, later investors generally pay more than they will ever recoup. At this point, the promoter retains a majority of the money from the investors’ initial sums and often does not need to pay out any recruitment compensation to later investors. This is because the pyramid scheme eventually collapses when later investors cannot find additional investors, called market saturation. The FTC estimates that around 89% of investors either cannot make a profit or cannot recoup their investment by the time a pyramid scheme collapses.
Pyramid schemes are often illegal. They differ from legitimate MLMs in that profit gained in an MLM is based mostly on product sales and not on recruitments. Pyramid schemes are related to Ponzi schemes, though there are some differences.
[Last updated in July of 2020 by the Wex Definitions Team]