How To Spot a Pyramid Scheme

In the classic “pyramid” scheme, participants attempt to make money solely by recruiting new participants, usually where:

• The promoter promises a high return in a short period of time;
• No genuine product or service is actually sold; and
• The primary emphasis is on recruiting new participants.

All pyramid schemes eventually collapse, and most investors lose their money.

Fraudsters frequently promote pyramid schemes through social media, Internet advertising, company websites, group presentations, conference calls, YouTube videos, and other means. Pyramid scheme promoters may go to great lengths to make the program look like a business, such as a legitimate multi-level marketing (MLM) program. But the fraudsters use money paid by new recruits to pay off earlier stage investors (usually recruits as well). At some point, the schemes get too big, the promoter cannot raise enough money from new investors to pay earlier investors, and people lose their money.

These are some of the hallmarks of a pyramid scheme:

Emphasis on recruiting. If a program focuses solely on recruiting others to join the program for a fee, it is likely a pyramid scheme. Be skeptical if you will receive more compensation for recruiting others than for product sales.

No genuine product or service is sold.  Exercise caution if what is being sold as part of the business is hard to value, like so-called “tech” services or products such as mass-licensed e-books or online advertising on little-used websites. Some fraudsters choose fancy-sounding “products” to make it harder to prove the company is a bogus pyramid scheme.    

Promises of high returns in a short time period. Be skeptical of promises of fast cash – it could mean that commissions are being paid out of money from new recruits rather than revenue generated by product sales.

Easy money or passive income.  There is no such thing as a free lunch. If you are offered compensation in exchange for doing little work such as making payments, recruiting others, or placing online advertisements on obscure websites, you may be part of an illegal pyramid scheme.   

No demonstrated revenue from retail sales.  Ask to see documents, such as financial statements audited by a certified public accountant (CPA), showing that the company generates revenue from selling its products or services to people outside the program.  As a general rule, legitimate MLM companies derive revenue primarily from selling products, not from recruiting members.

Complex commission structure. Be concerned unless commissions are based on products or services that you or your recruits sell to people outside the program. If you do not understand how you will be compensated, be cautious.

All Pyramid Schemes Collapse

When fraudsters attempt to make money solely by recruiting new participants into a program, that is a pyramid scheme, and there is only one possible mathematical result – collapse. Imagine if one participant must find six other participants, who, in turn, must find six new recruits each. In only 11 layers of the “downline,” you would need more participants than the entire population of the United States to maintain the scheme. If you a suspect that you’ve been approached about a pyramid scheme, then warn your family and friends.

How Can You Avoid Being Defrauded?

The easiest way to avoid being defrauded is obviously not to participate in any promotion that appears to be a pyramid scheme. The following are some additional tips to help you steer clear of pyramid schemes:

• Gather all information regarding the company, its officers, and its products or services. Get written copies of the company’s marketing plan, sales literature, contracts, etc. Avoid promoters who fail to explain their plans clearly and in detail. In particular, read the company’s prospectus or other written material. (A prospectus is a legal document that gives prospective investors information about a company.) If you don’t understand it, get someone independent of the company to explain it to you.

• Find out if there is a demand for the product or service. Is there a similar product or service on the market? If so, how well does it sell? If the promoters seem to be making most of their money by selling distributorships or large start-up inventories to new recruits, stay away.

• Ask if you must buy a product to become a distributor. Find out if the company will buy back your inventory –you could get stuck with unsold products. Legitimate companies will buy back inventory for at least 80 to 90 percent of what you paid. Get all promises in writing.

• Beware if the start-up cost is substantial. Some pyramid schemes pressure you to pay a large amount to become a “distributor.” What are you getting for your money? Beware of promises of quick, easy and unreasonably high profits.

• If the distributorship is providing a product for use to make a final product, make sure that whatever you provide reaches the final manufacturer. If you can, call or visit the manufacturer and ask for a list of its customers. Call the customers and ask if they are satisfied with the product.

• Resist the temptation to invest just because the people selling you the program are friends or are part of your religious or social organization. They may have been misled into believing that they could make large amounts of money in a short time.