What are Ponzi vs. Pyramid Schemes?
Investors need to be knowledgeable about where they put their money into, particularly about Ponzi vs. pyramid schemes. While the schemes are somewhat similar in how they are operated, there are distinctive differences in their structure.
Additionally, while a Ponzi scheme is an outright case of fraud, it is possible for investors in pyramid schemes to legitimately earn a return on their investment. The differences between Ponzi vs. pyramid schemes can most easily be seen by examining the definition, nature, and operation of each.
- Ponzi schemes and pyramid schemes are often confused with one another; however, each comes with a distinctly different structure and mode of operation.
- Ponzi schemes are outright frauds, while pyramid schemes may or may not be part of a legitimate business opportunity.
- The major similarity between Ponzi schemes and pyramid schemes is that both require a continual flow of new investors in order to be sustained; once the flow of new investors begins to dry up, the scheme collapses.
Ponzi schemes are named after the originator of this particular fraud – Charles Ponzi – who scammed large numbers of investors by promising them a 50% or better return on their investments in postal coupons. However, rather than actually making any investments, Ponzi simply pocketed the investors’ money for himself. He was able to continue the scam by attracting new investors and using part of their money to pay returns to earlier investors.
In return, the earlier investors would help Ponzi attract new investors by bragging about the amazing returns they were earning with him. However, ultimately, Ponzi got to the point where he couldn’t attract enough new investors to pay off the growing number of previous investors. At that point, the scam was discovered, and it fell apart.
Step-by-Step Process – Ponzi Scheme
- The fraudster attracts an investor by promising them extraordinary returns on investment. As an example, assume the perpetrator of the Ponzi scheme gets an initial investor to give him $1 million to invest, promising a return of 25% or better.
- The fraudster never invests the money received and just takes it for themselves.
- They attract a second investor, who also invests $1 million. Out of that money, the fraudster pockets $750,000 and uses $250,000 to pay the previous investor his 25% “return.” Keep in mind that the investor’s $1 million has never been invested in anything, but they believe that it has been and that it will continue to earn huge returns.
- The fraud can continue until the schemer can’t bring in enough new money to pay “returns” to all the previous investors. For example, assume that the operator of the Ponzi scheme has managed to attract 100 investors – all investing approximately $1 million each – and is bringing in approximately ten new investors each month.
The problem at that point is that even all of the money invested by the month’s new investors is not sufficient to pay 25% “returns” to 100 previous investors. Thus, the scheme collapses, and the fraud is discovered.
Ponzi scheme operators often add to their income by charging investors sizeable fees for their (non-existent) managing of investor funds.
Ponzi Scheme Example – Bernie Madoff
Probably the most famous (or infamous) Ponzi scheme was the one run by Bernie Madoff. Madoff managed to sustain a Ponzi scheme for almost two decades, during which he stole billions of dollars from investors. By the time his scam was uncovered, much of the money was long since spent and gone. Therefore, Madoff being sent to prison was of little comfort to his defrauded investors.
A pyramid scheme is a multi-level marketing business model where members pay a fee to invest in the business and are then, in turn, promised payments for recruiting other people to likewise invest in and join the business. The scheme gets its name from the structure of the business – larger numbers of investors below, all paying money that is divided up among smaller numbers of investors above them.
A pyramid scheme typically involves a business offering products for sale. However, investors are rarely able to earn a satisfactory return solely by selling the company’s products. To make money, they must recruit a certain number of new investors below themselves. Not only that, but each person they recruit must also recruit a certain number of people, each of whom pays an entry fee or joining fee and a monthly fee to maintain their membership.
The originators of the business easily make a profit, as they receive all or part of the money received from each new investor. They make the business appear attractive by showing new recruits how much money they will be making after they recruit.
For example, let’s say there are six people, and those six people each recruit six more people, who then each recruit six more people, and so on and so on. Thus, new business prospects are shown a picture of eventually having thousands of other people beneath them, each of whom is contributing money monthly, part of which goes to each individual directly above them in the pyramid model.
The problem is that successfully building a large “pyramid” of people beneath you is, in most cases, next to impossible. You may well be able to recruit six people. However, the odds of each one of those six people duplicating your feat are very slim. Most people, after failing to recruit the necessary numbers of new people, simply drop out of the pyramid scheme. The promised massive downline of hundreds or thousands of people beneath you, contributing to your monthly income, never materializes.
In short, while it is theoretically possible for investors in a pyramid scheme to make a profit, in reality, that rarely happens. The only people guaranteed a return are those at the very top, the business’ founders who make money from everyone who joins and invests in the business for any length of time, at any level. Most people, after shelling out the initial fee to join and paying the required monthly membership fee for several months, see that the pyramid scheme is unworkable and drop out, without ever so much as earning back their original investment.
Because it is theoretically possible to earn money from a pyramid scheme, it is often difficult to identify the business operating one as outright fraud. The distinguishing characteristic is usually the fact that money can only really be made through massive recruiting of new members rather than through anyone selling the company’s products.
It can be seen that a key difference between Ponzi vs. pyramid schemes is the fact that while both involve attracting new investors, the participants in a Ponzi scheme do not typically have any active involvement in recruiting new investors, while the participants in a pyramid scheme must be actively involved in recruiting new investors to succeed.
Pyramid Scheme Example – BurnLounge
BurnLounge was a multi-level marketing company operating as a pyramid scheme, where investors obtained the right to sell music through the company’s network. The U.S. Federal Trade Commission (FTC) eventually identified the company as operating a fraudulent pyramid scheme rather than a legitimate business opportunity and shut it down. Nearly $2 million was repaid to investors in the business.
CFI is the official provider of the global Commercial Banking & Credit Analyst (CBCA)™ certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional CFI resources below will be useful: