Pyramid Schemes: What They Are and How They Work

By

Ross James

|

Pyramid Schemes

Table of Contents

Introduction

Pyramid schemes are a type of business model often promoted as a way to achieve rapid financial success. Despite their appeal, pyramid schemes are illegal in many countries due to their unsustainable and often deceptive structure. They differ significantly from legitimate Multi-Level Marketing (MLM) and network marketing companies, although the lines can sometimes blur. In this article, we’ll explore what pyramid schemes are, how they work, and how to distinguish them from legitimate MLM opportunities. We’ll also review compensation plans that tend towards pyramid schemes and those that do not, providing insight into ethical and sustainable network marketing practices.

pyramid sschemes

What Is a Pyramid Scheme?

A pyramid scheme is a fraudulent business model where participants earn money primarily by recruiting others into the scheme rather than by selling a product or service. The structure resembles a pyramid, with a single individual at the top and new recruits forming subsequent layers beneath. As new recruits join and pay fees or purchase starter packages, the initial members at the top of the pyramid earn commissions. However, this model is inherently unsustainable because it relies on an ever-increasing number of recruits to sustain profits.

In a classic pyramid scheme:

  • Recruitment is the primary source of income: Participants are paid mainly for bringing in new members, not for product sales.
  • Growth relies on new participants: The scheme requires exponential growth to survive, leading to inevitable collapse when no more recruits are available.
  • Most participants lose money: A small percentage of participants, usually at the top, make substantial profits, while the majority lose their investments when the scheme collapses.

How Pyramid Schemes Work

To understand how a pyramid scheme works, imagine a scenario where a recruiter invites individuals to invest in a new “business opportunity.” This recruiter, or the person at the top of the pyramid, may charge a joining fee or require an initial purchase of products that carry a substantial price. Each new participant is then encouraged to recruit more people to earn back their initial investment, creating a cycle of recruitment that benefits those higher up the chain.

As the pyramid expands:

  • New members pay fees to join: New recruits pay a significant amount to join, which is often divided among the recruiters above them.
  • Pressure to recruit more people: Members are incentivized or pressured to recruit friends, family, and acquaintances to recoup their investment.
  • Limited income sources: Participants depend primarily on recruitment rather than the sale of products or services.
  • Collapse is inevitable: Eventually, the number of people who can join is exhausted, and the pyramid collapses, leaving most participants at a loss.

Recognizing the Difference Between Pyramid Schemes and Legitimate MLM/Network Marketing

Not all MLM or network marketing companies operate as pyramid schemes. Legitimate MLMs focus on selling products or services rather than recruiting members as a primary income source. While participants in MLMs may also recruit others and earn commissions on their downlines, the difference lies in the source of income and compensation structure.

Key differences include:

  • Product-based income: Legitimate MLMs derive the majority of income from product sales rather than recruitment.
  • Sustainable growth: A legitimate MLM does not rely on constant recruitment to sustain its business model. Instead, revenue comes from ongoing product purchases by customers.
  • Emphasis on customers, not just recruits: A sustainable MLM encourages representatives to build a customer base rather than focus solely on recruitment.

Types of Compensation Plans in MLM and Network Marketing

Understanding the compensation plan in an MLM is crucial to determining whether the business model leans toward a pyramid scheme. Let’s examine some common compensation plans and their features.

1. Binary Compensation Plan

In a binary plan, each distributor recruits two others and builds a downline of two teams. This plan can quickly expand, but to earn commissions, both “legs” or “teams” must be balanced. 

  • Pros: Can create a steady source of income if both legs are active with sales.
  • Cons: If one team grows faster than the other, the distributor may not earn commissions on the excess. Some binary plans have a cap on earnings, which can limit potential income.

Pyramid Potential: While not inherently a pyramid scheme, binary plans may encourage excessive recruitment to balance teams. When product sales are secondary to recruitment, it can resemble a pyramid scheme.

2. Unilevel Compensation Plan

In a unilevel plan, each distributor can recruit an unlimited number of frontline members, with no limit on the number of levels from which they can earn commissions.

  • Pros: Simplicity and flexibility in recruitment. Rewards are based on the entire downline, not on keeping teams balanced.
  • Cons: Income is tied to the distributor’s ability to motivate recruits to sell products, which can be challenging at lower levels.

Pyramid Potential: Unilevel plans are generally more sustainable as they allow for unlimited growth and do not necessarily pressure participants to recruit heavily. However, plans that focus on recruitment bonuses over product sales could still resemble pyramid schemes.

3. Matrix Compensation Plan

A matrix plan limits the number of recruits per level (e.g., 3×3 matrix, where each distributor can recruit three people on each level). When a level is filled, recruits are placed in the next available slot in the downline.

  • Pros: Discourages constant recruitment, as each level has limited spots. Earnings rely on both recruitment and product sales.
  • Cons: Can lead to “spillover,” where excess recruits benefit upline members but not necessarily the recruiter.

Pyramid Potential: A matrix plan can be sustainable if product sales are prioritized. However, when compensation relies heavily on filling spots, it may veer toward a pyramid structure.

4. Stairstep Breakaway Compensation Plan

Stairstep plans involve achieving ranks based on both sales and recruitment, with higher ranks providing bonuses or overrides on downline sales.

  • Pros: Encourages personal sales for rank advancement. Higher earning potential for those actively selling and recruiting.
  • Cons: May put pressure on distributors to recruit to move up ranks.

Pyramid Potential: Stairstep breakaway plans can be legitimate if the emphasis is on personal and downline sales rather than recruitment alone. However, they can veer towards a pyramid scheme if income is primarily tied to achieving ranks through recruitment.

Signs That an MLM May Be a Pyramid Scheme

  • High Emphasis on Recruitment: If a company’s primary focus is on recruiting rather than product sales, it may be a pyramid scheme.
  • Lack of Genuine Customers: Pyramid schemes typically have very few external customers, as income is generated primarily from participants.
  • High Entry and Ongoing Fees: If distributors must pay significant fees to join and continue in the business, this can be a warning sign.
  • Unrealistic Income Claims: Companies promising massive returns with little effort are often pyramid schemes.
  • Complicated Commission Structures: Overly complex plans that reward participants based on recruitment rather than product sales can be suspicious.

Compensation Plans with Low Pyramid Scheme Potential

  • Single-Level Direct Sales: Income is based solely on product sales with no recruitment requirements. Examples include direct selling businesses like Avon or Tupperware.
  • Retail-Driven Unilevel Plans: When commissions are based primarily on retail sales and bonuses are provided for high sales volumes, these plans are typically sustainable.
  • Customer-Focused Matrix Plans: In cases where earnings depend on a stable customer base rather than just recruiting, these plans are generally safer.

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Conclusion

While MLM and network marketing companies have sometimes been confused with pyramid schemes, understanding the structure and compensation plan can help differentiate between the two. Pyramid schemes are unsustainable and often illegal, with income driven by recruitment rather than genuine sales. Conversely, legitimate MLMs focus on product sales, offering a feasible path to success without solely relying on recruitment. By examining the compensation plan, assessing the company’s emphasis on sales, and verifying customer demand, participants can make informed choices and avoid falling into the trap of a pyramid scheme.

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