Pyramids Schemes ExplainedUpdated: Nov 7, 2016
Pyramids Schemes Explained
A pyramid scheme is a type of investment scheme in which investors earn profits from the recruiting of new members to the scheme; all pyramid schemes inevitably fail because they rely on geometric growth to sustain returns for the investors, and eventually reach a point at which they collapse. A pyramid scheme is similar to a Ponzi scheme in that it relies on ever-increasing numbers of later investors to provide returns for earlier investors, but differs in that returns for investors are directly tied to the number of new investors each can recruit. Multi-level marketing (MLM) programs, which are legal in most places, are actually a form of pyramid scheme. There are a number of variations in the form of pyramid schemes. The three most common are the simple pyramid scheme, the 8-Ball Model, and the 2-Up System; the latter two are the basic format, with some slight adjustments, of most MLM systems.
Simple Pyramid Schemes
The simplest form of a pyramid scheme is also sometimes called a “chain-letter” scheme. The starter of the pyramid will recruit some number of investors, each of whom will pay him a certain amount. The second group of investors each recruits the same number of investors, thus earning several times over their original investment, i.e. the amount they each paid to the first investor at the tip of the pyramid. In order to earn a profit, each investor in each successive level must recruit the same number of people.
For example, Investor Number One at the top of the pyramid recruits six new members for $1 each, earning a profit of $6. These six recruits then recruit six new members each, earning $5 profit and adding 36 people to the pyramid. In order to earn their profit, the 36 members on the third level of the pyramid must recruit a total of 216 people, who subsequently must recruit 1,296 people, and so on. This illustration published a few years ago by the US Securities and Exchange Commission shows how this pyramid scheme quickly becomes unrealistic:
This kind of pyramid scheme is illegal everywhere, for obvious reasons; the only investor who is guaranteed a return is the one at the top of the pyramid, and practically speaking, anyone below the fourth or fifth level of the pyramid is likely to lose 100% of his investment.
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The 8-Ball Model
The 8-Ball Model, which is called that because a diagram of it resembles a rack of billiard balls, is a format used by some MLM schemes. In an 8-Ball scheme, members do not receive a profit from new recruits until three levels are recruited. For example, Company X is set up so that each new member can collect a $100 payment for “starter kits” for new members (this kind of arrangement is made because of laws in most places requiring that members of an MLM program receive goods of “equivalent value” for any “membership fee” or initial investment they make). But, payment is not made until the third generation of recruits. Member 1 recruits two new members, who recruit four, who recruit eight new members. These eight pay a total of $800 to Member 1. When the eight members on the third level of the pyramid recruit their two new members each, the two originally recruited by Member 1 receive $800 each from the 16 new level-four members. The bottom three levels in an 8-Ball Model will always lose 100% of their investment, no matter how many levels there are.
The 2-Up System
The 2-Up System is a variation that is used by MLM schemes because it encourages recruits to work harder to recruit new members. In a 2-Up format, the “sales income” – which might be actual sales of products, or might simply be the initial “starter kit” purchase – from the first two people a person recruit goes to that person’s own recruiter; the sales from the third and any subsequent recruits then go to that person.
In a 2-Up System, the bottom level always loses 100% of their investment, while the second-lowest level always breaks even. The 2-Up System is used in MLM schemes, because the opportunity for income grows exponentially as one moves higher up the pyramid; however, it requires that three times as many people be recruited for each new level in order for the preceding level to earn a profit, and quickly runs out of available recruits (particularly if they’re smart, and realize they’re being rooked).
Differences between MLMs and Pyramid Schemes
The only difference between an MLM and a regular pyramid scheme, and what makes MLMs legal while pyramid schemes are not is that the sale of products at least theoretically gives members the opportunity to earn income without recruiting new members. So in the example 2-Up System in the diagram above, the network would not necessarily have to expand beyond the four levels that are shown.
Let’s suppose that the company represented by the diagram sells a product which has a cost to dealers of $9, and retails for $10. Let’s also suppose (to keep things simple) that the top level (the black oval) was recruited by the company directly, and that the top level recruit does not actually sell any products, preferring to simply profit from the sales of his “downstream”. If each member below the top level sells one product, the top level makes $7, the second level makes $3, the third level makes $1 each, and the fourth level makes no profit at all – exactly the same proportion of returns as if the framework were a naked pyramid scheme. The company (the recruiter of the top level in this example) is guaranteed a profit of just $2 from a total of 15 products sold.
That should tell you something about the real cost (and likely the quality) of products offered through multi-level marketing schemes, as well as the futility of investing in one. Unless you are fortunate enough to be near the top of the pyramid – whether it’s a legitimate (if only just) MLM program or an actual pyramid scheme – the claims of high returns these schemes offer mean, “High returns for those who came before you.” Best to do your homework, and find safer ways to invest your money.