Updated July 10, 2023
What is a Pyramid Scheme?
The term “pyramid scheme” refers to an illegal investment scheme based on a hierarchical network marketing setup. The members at the top recruit new members who pay upfront costs up the chain to the top-level members who enroll them. Again the newly recruited members bring in underlings of their own, and a certain percentage of the following fees is also sent up the chain. Pyramid scheme operations are termed illegal in many countries.
How Does Pyramid Scheme Work?
A typical pyramid scheme structure is built to induce the members to recruit subordinates and collect fees from them that eventually go to the top of the pyramid. For example, one person recruits a second person who invests a certain sum of money in joining the scheme. The second person later recovers the investment by bringing in other people under them who invest in the scheme.
The more people one can recruit, the greater their profit. Besides, a certain percentage of the profit of recruitment makes its way up the pyramid. So, effectively each person has to enroll a certain number of people, and the process continues until the scheme collapses because of fewer people at the bottom of the pyramid. Typically, some people near the top of the pyramid earn huge profits, while those near the bottom can never recover their investments.
Example of Pyramid Scheme
Let us take a simple example to understand the concept of a pyramid scheme. Let us assume that David is the founder of a pyramid scheme and is at the top of the pyramid. First, he recruited ten second-tier people who paid him fees for joining the pyramid scheme. In the next stage, each of these ten second-tier members recruited ten third-tier members of their own, which means 100 third-tier members. These 100 third-tier members also have to pay fees to the second-tier recruiters, a percentage of which goes up to David. This is how the recruitment process goes on, and the top-level members make money out of the recruitment without having any business operations to generate cash.
Types of Pyramid Scheme
1. Multilevel Marketing Plans
Not all, but some multilevel marketing businesses turn out to be pyramid schemes. In these schemes, the members are required to sell different products. Additionally, they must recruit new participants that yield returns on top of the sales commissions.
2. Chain Email
The donation fund operates as an email-based system, requiring each recipient to donate a certain amount of money (for a humanitarian cause) to the individuals listed in the email. Subsequently, the recipients forward the email to their contacts, adding their names at the top of the recipient list. This type of scheme, aimed at deceiving innocent people, is considered illegal.
3. Gifting Clubs
In these schemes, the team often lures new participants with promises of gifts in return for recruiting new members. The top-level members are then gifted by the new entrants, usually in the form of cash.
4. Naked Scheme
In these schemes, the only source of profit is the fees earned by recruiting new participants. Each person must recruit some participants, who in turn have to recruit more people similarly. This eventually results in a hierarchical pyramid. Here, every new member has to pay the joining fees.
Why is Pyramid Scheme Illegal?
In a pyramid scheme, an individual or a company starts the scam by recruiting members (or investors) and offering high guaranteed returns. Initially, the earliest investors can make a significant amount of money, primarily paid out of the new recruitments and not as any return on some real investment. However, the scheme starts to lose steam when the liabilities begin to exceed its assets because of tapering recruitment, eventually leading to the falling of the pyramid. So, this business can generate wealth by deceiving people and offering them extraordinary returns based on recruits, which is not a legal business model. This is the reason that pyramid schemes are termed illegal in many countries.
Advantages of Pyramid Scheme
Some of the major advantages are as follows:
- Unlike a normal job wherein people must meet a fixed number of hours, the members of these schemes enjoy the freedom to function at their speed.
- The earliest members can earn high returns by adding fresh recruits and bringing in more people to the business resulting in more profits.
Disadvantages of Pyramid Scheme
Some of the major disadvantages are as follows:
- It is akin to contracting or freelancing; hence, there are no conventional benefits, such as compensated leave, health care, etc.
- The investments paid as joining fees are usually not returned to the latest members joining at the bottom of the pyramid.
Some of the key takeaways of the article are:
- A pyramid scheme is an illegal or fraudulent business model in which the top-level members earn profits from the joining fees collected from the new members at the lower levels of the hierarchy.
- These businesses primarily rely on earning profits from recruitment fees and seldom have any intrinsic value owing to any sale of actual goods or services.
- A pyramid scheme collapses when the entity cannot attract new members at the bottom to pay off the members sitting at the top.
It is a form of financial scam or fraud that makes money by attracting new members to pay off the earlier members. There can be many variants of the pyramid scheme. So, investors must do their due diligence before investing in any business. If anything looks fishy or suspicious, it is always best to walk away.
This is a guide to Pyramid Scheme. Here we also discuss the definition, working, example, types, and why is Pyramid Scheme illegal, along with its advantages and disadvantages. You may also have a look at the following articles to learn more –