How to Spot a Pyramid Scheme (and Avoid Losing Your Money)

Bernie Madoff’s arrest in December of 2008 brought renewed attention to the concept of a Ponzi scheme. The close cousin of the Ponzi scheme, named for Charles Ponzi who swindled investors in the 1920’s, is a “pyramid scheme.”

Similar to a Ponzi scheme, a pyramid scheme is a form of fraud that promises participants payment for enrolling other people into the scheme, rather than from any legitimate investment or sale of services or products. It is important to distinguish between the characteristics of a pyramid scheme and a Ponzi scheme:

  • In a Ponzi scheme, the schemer acts as a main point of contact for the victims (i.e., Bernard Madoff). In a pyramid scheme, those who recruit additional participants benefit directly.
  • A Ponzi scheme claims to rely on some obscure investment approach and usually attracts high-net worth individuals. A pyramid scheme explicitly claims that new money will be the source of payout for the initial investments.
  • A pyramid scheme is prone to collapse much faster, because it requires the number of participants to increase exponentially in order for it to be sustainable. A Ponzi scheme, by contrast, can survive simply by persuading most existing participants to “reinvest” money. So, it doesn’t require as many new participants.

Related: What It Takes to Run An Online Business

What Does It Look Like?

These days, you may be more likely to be targeted by a pyramid scheme than a true Ponzi scheme. However, any time someone asks you to make an investment that seems sketchy, be wary!

Here’s an example of a pyramid scheme:

  • The representative asks you to make an initial investment of $500 to become an independent agent for a discount long-distance phone company. They say you’ll earn hundreds of dollars per week.
  • Your job is to sell the service AND recruit a sales force to increase returns.
  • Under this scenario, the company requires you to sign up a certain amount of people for a specific period of time, such as six months or one year. Most agents usually find few new recruits and end up losing money because they need a huge number of recruits to earn more.

How to Spot a Pyramid Scheme

So, how can you spot a pyramid scheme before it’s too late?

Victims are often vulnerable to “get rich quick schemes.” Typical victims include the elderly, recent college graduates, or new immigrants. The schemer will ask you to recruit friends and family, too.

Companies or participants involved in pyramid schemes normally don’t have an actual, marketable product or service. In other words, if you can’t trace the company’s revenues back to tangible sales, they’re likely taking you for a ride. In these cases, revenues usually come from entry fees, training programs, and recruitment instead of actual sales.

Sometimes, though, these companies do offer a product. The company may require you to buy a certain amount of inventory in the company’s product in order to get started.

Resource: How to Avoid Startling Work-from-Home Scams

According to the Direct Selling Association of America (DSA), if agents of a business are not able to sell inventory, some states require buy-backs at a percentage of the original cost. If a company is recruiting you to sell actual products, ask about its buy-back policy. Throw up the mental red flag if the company doesn’t offer buy-backs.

These businesses, whether they offer a real product or not, tend to generate hype around their so-called products or services. They hope potential recruits will simply ignore the downside of this business model.

In other words, you should be wary of any company promising quick returns in highly-charged meetings. Many, though not all, of these businesses offer too-good-to-be-true high tech ideas or New Age health and environmental products.

What About MLMs?

So, this is all about a true pyramid scheme, which is basically setting up new recruits to fail. But some companies actually offer a legitimate multilevel marketing (MLM) model. It can be easy to confuse the two sometimes.

According to the Better Business Bureau, an MLM does offer legitimate products or services. Sometimes these products are even quite good. Salespeople buy inventory from the company and then sell directly to friends and family.

They can earn more by recruiting a team of sales people under them. Typically, they’ll earn money for all of their own sales, plus money for the sales of everyone they brought into the business.

The BBB lists the following signs that an MLM may be a scam:

  • Promises of high earnings with little effort
  • Requirement to purchase a large amount of inventory up front, with no written buy-back promise
  • Request for payment in cash, money order, or wire transfer for the first payment

With all this said, some MLMs do offer legitimate opportunities for a work-from-home business. But business is the key term here. To be successful in an MLM, also called a network marketing business, you have to put in time and effort. Some of today’s well-known MLM brands include Advocare, Melaleuca, Mary Kay, and Younique.

Do Your Own Research

Sometimes, MLMs can be a way to get products you already like at a discount. For instance, you could become a representative for Mary Kay. If a few family members and friends purchase from you, you could pay for the makeup and skincare products you were already going to buy.

Some people can make a decent side income from the right network marketing business. But it’s often more expensive to get started than it’s worth.

It’s essential that you do your own research. Talk to people who are currently selling the company’s products or services. Dig into potential issues, as well as the company’s revenue stream. Understand how the products work, what kind of commission you get, and how the company helps you make sales.

Any company whose model is based on high-pressure decisions and quick investments is likely a scam. Take your time. Do your research. Start with the Better Business Bureau or the Direct Selling Association.

Do everything in your power to avoid letting yourself be fooled. People will always dream about getting rich quick, but it’s usually not that easy.


Topics: Investing

3 Responses to “How to Spot a Pyramid Scheme (and Avoid Losing Your Money)”

  1. Richard Hurt

    I agree with 99% of what you have said here, and unfortunately many innocent people are falling for these schemes at a time when they are looking for anyway they can to provide for themselves and their families. They are either unemployed or under-employed. Not all are just looking to get rich fast. But one thing we can’t do is lump all MLM companies into the pyramid scheme category. There are several legitimate MLM companies out there, even if they are companies I or you might not want to work for (i.e. Amway Global). MLM is not my bag, but it can be legit. Good article.

    • Michael

      Rich

      Funny you should mention Amway Global, because when I was 15 working at McDonalds, a co-worker approached me about Quixstar (which was Amway Global at the time). I ended up meeting “a guy” at the local Pizza Hut who tried to sell me on the idea but I came out of it thinking “100% scam”.

      As of today, I really don’t know how Amway Global works (although I see commercials everyday) but my impression will always be scam.

  2. A Ponzi scheme is like Social “In”Security. The people that initially put into the Communist program got the greatest the greatest return though they put very little into it, whereas later in the scheme those putting the most into it are getting the least return.
    A pyramid is any corporation (P&G, GE, ING, etc) that has 1 person at the top making the big bucks and then a few senior management and fewer at mid level mgmt and many at entry level mgmt and many more at supervisory level and gobs more at ground floor thus a pyramid where many are willing to stab others in the back to claw their way to the top. It is ugly.
    However a direct sales, network mktg, MLM company is just the reverse with the top wide open for anyone willing to work in order to achieve financial wealth and freedom. Even corp America’s sales depts recruit and the regional and district mgrs get a cut off of the sales efforts of all the sales reps in their region or district. What about insurance agencies? The same thing.
    Please wake up and THINK!

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