A pyramid scheme is an unsustainable, illegal business model where investment returns are typically from principals of investments or membership fees instead from the underlying investment gains. It is often marketed as a foolproof way to turn a small amount of money into big returns.
A typical pyramid scheme begins with an initial recruiter attracting investors by promising high returns on their investments. The initial recruiter is at the top of the “pyramid.” After investors give their investment money or membership fees to the initial recruiter, they become “level-1” members. They must recruit a certain number of “level-2” members to make their returns. The “level-2” members in turn must recruit “level-3” members and so on. All the members must make investments or pay membership fees. The initial recruiter and early investors are paid from the principals of investments or membership fees from the later investors. As the membership size grows, the pyramid eventually collapses because later investors are unable to recruit more members. Only the initial recruiter and if any, a very few early investors make money while the rest lose money.
Although a pyramid scheme may sound tempting, it is unsustainable. To illustrate, assume that an initial recruiter devises a pyramid scheme, where each member must recruit nine new members. In such a scheme, the number of members required to sustain the pyramid at level 9 would be 387 million or more than the population of the United States. The following table shows the number of members required to sustain the pyramid at each level:
|Level||Number of Members|
Required to Sustain
Legitimate multi-level marketing (MLM), also known as network marketing, is often confused with pyramid schemes because MLM offers a tiered compensation system whereby a member who recruits a new member will get a cut of that new member's sales commissions. It can be distinguished from a pyramid scheme by determining the source of the returns. Returns from real product sales or investment gains are likely to be legitimate, while returns from principals of investments from later investors are likely to involve illegal pyramid schemes.
Investors should watch for the following warning signs of pyramid schemes:
- promises of unrealistic returns on investments
- high upfront fees or investments
- strong emphasis on the legality of the business
- no clear descriptions of products, services, or investments being offered
- no real underlying investment
For more information, see:
- Pyramid Schemes, The Securities and Exchange Commission (SEC): http://www.sec.gov/answers/pyramid.htmThe SEC describes pyramid schemes.
- Investor Alert: Beware of Pyramid Schemes Posing as Multi-Level Marketing Programs,The Securities and Exchange Commission (SEC): http://www.sec.gov/investor/alerts/ia_pyramid.htm The SEC provides tips for avoiding pyramid schemes that masquerade as legitimate MLM programs.
- Don't Get Caught in a Pyramid Scheme, New York State Attorney General: http://www.ag.ny.gov/consumer-frauds/pyramid-schemes The New York State Attorney General’s Office compares a pyramid scheme with MLM and provides tips for avoiding a pyramid scheme.