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Pyramid Scheme

An unmanageable business model in which original investors make money by recruiting others

What is a Pyramid Scheme?

A pyramid scheme is an unsustainable business model in which original investors make money by recruiting others rather than selling actual products or services. The model works by asking new investors to make an upfront payment so that they can be allowed to join the scheme. The money received from the new recruits is used to pay off the earliest investors. The new members are then promised earnings if they are able to recruit more people into the scheme.

 

Pyramid Scheme

 

Although the concept behind pyramid schemes sounds simple, it is usually presented to investors in a disguised form. Therefore, it’s important to familiarize oneself with how it works, as well as the different shapes that it can take.

 

How Pyramid Schemes Work

As its name suggests, the scheme takes the structure of a pyramid. It starts with one individual –  the original recruiter – who is at the apex of the hierarchy. The individual recruits one person, who is required to invest a certain amount of money. The upfront payment is then paid to the original recruiter. For the new recruit to recover his investment, he or she must recruit more members under him, each of who will also make an upfront investment.

If the recruit manages to get 10 or more people to join, he would’ve earned a substantial amount of profit from just a small investment.

Each of the newly recruited members must get more people to join, meaning that there’ll be at least 100 new members. For every 10 people that an individual brings on board, he or she earns a substantial profit minus the initial payment he made to the individual who recruited them.

The recruitment continues to the point that the scheme can no longer support itself. At such time, those at the top of the pyramid have earned huge profits while those at the base end up losing their investment.

The problem is that such a scheme cannot thrive for a long time. There are only so many people who can join. Members are deceived into thinking that by investing, they will make a lot of profit. However, in reality, neither the scheme has resulted in the creation of any wealth nor the scheme’s organizers have purchased any assets.

 

Pyramid Scheme - How It Works

 

Forms of Pyramid Schemes

 

1. Multi-level Marketing (MLM)

Unlike other kinds of pyramid schemes, multi-level marketing (MLM) is actually a legal business practice. It involves recruiting members to help with selling a product or service that provides value. The recruit earns a profit when they sell the product, and they’re not necessarily required to get more people to join.

So, the main difference between other pyramid schemes and multi-level marketing is that the latter provides a genuine product or service while the former doesn’t.

But even then, one may find a version of MLM that exists as an MLM pyramid scheme. It means that the variant would involve selling products or services with little to no value. For example, it can involve selling printed materials such as courses on investments. Such a scheme is able to sustain itself by luring recruits to purchase the non-valuable products at high prices.

 

2. Gift promotions

Some of the schemes come disguised as gift promotions. They often occur in investment clubs. The way they work is that a recruiter is given a gift. If the new recruit is able to get more people to join, he too receives a gift from those he recruits. The schemes are often part of club programs and are considered illegal.

 

Attributes of a Pyramid Scheme

Pyramid schemes have some common characteristics that one should watch out for. They are:

 

1. Emphasis on recruitment

If there’s a program that’s placing a lot emphasis on getting others to join, chances are that it’s illegal.

 

2. No sale of actual product or service

One should be very cautious about schemes that don’t involve the sale of any genuine products or services. Some fraudsters will look for fancy-sounding products to make it easier to deceive people.

 

3. Promises of high returns within a short time

If one is being offered a way to make quick cash within a very short time, they should be skeptical about such schemes. The only way a program can yield quick profits is if payments from new recruits are being used to pay off early investors.

 

4. No proof of revenue from retail sales

Before joining any scheme, one should ask for proof of revenue. For example, they can ask to see financial statements, which should be audited by a professional CPA. The records will show the kind of activities the company is involved in. As a rule of thumb, a scheme should be getting revenue from the sale of products or services and not from recruiting individuals.

 

Summary

A pyramid scheme is a scam that is founded on an unsustainable business model. It involves getting individuals to join some sort of an investment scheme at a fee. The new recruits then need to get more people to join so that they can recover their investment and make profits.

The recruitment process continues until the cycle is unable to sustain itself. By the time the scheme falls apart, the earliest investors (those at the top of the pyramid) will have earned significant profits while the most recent members will have lost on their investments.

 

Related Readings

CFI is the official provider of the Financial Modeling and Valuation Analyst (FMVA)™ certification program, designed to transform anyone into a world-class financial analyst.

To keep learning and developing your knowledge of financial analysis, we highly recommend the additional resources below:

  • Audited Financial Statements
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