Definition
A pyramid scheme is an unsustainable business model where initial profits are generated primarily through the investment of new participants rather than through legitimate business operations. New enrollees are enticed to invest substantial upfront payments with the promise of high returns primarily driven by enrolling others into the scheme. Ultimately, these schemes collapse when new recruitment declines, leaving the latest enrollees with substantial losses.
Phonetic
The phonetics of the keyword “Pyramid Scheme” are: /ˈpɪrəmɪd skiːm/
Key Takeaways
- A pyramid scheme is a business model that recruits members via a promise of payments or services for enrolling others into the scheme, rather than supplying investments or sale of products. As recruiting multiplies, recruiting becomes quickly impossible, and most members are unable to profit; as such, pyramid schemes are unsustainable and often illegal.
- Pyramid schemes rely on recruitment of new members to bring in money. The people at the top of the pyramid reap significant profits, while people at the bottom see little to no profits. When the scheme eventually collapses, usually because it gets harder and harder to recruit new members, the majority of participants lose money.
- Many pyramid schemes are branded as ‘multi-level marketing’ (MLM) opportunities. However, MLM businesses sell actual products or services, whereas pyramid schemes do not. A good rule of thumb to distinguish between a legit MLM and a pyramid scheme is that if the money is mostly generated through recruitment rather than product sales, it is likely a pyramid scheme.
Importance
Understanding the term “Pyramid Scheme” is crucial in the business/finance world as it refers to a fraudulent system of making money based on recruiting an ever-increasing number of investors. The initial promoters recruit investors, who in turn recruit more investors, and so on. Returns for the original promoters are paid out of investments of new entrants, and not from profits. This unsustainable business model often leads to the collapse of this system, resulting in financial loss for participants, particularly those who join at the later stages. Identifying pyramid schemes can help individuals avoid potential fraud and protect their investments.
Explanation
A pyramid scheme is primarily used as a dishonest and unsustainable business model utilized by certain individuals or companies with the goal of making a quick profit. At its core, a pyramid scheme incentivizes participants to contribute large sums of money or invest in a certain product or service, with the understanding that they will reap significant profit by recruiting others to do the same. The main purpose of such schemes is to benefit those who are at the top of the pyramid; their earnings are sustained by the constant flow of money from new participants lower down the pyramid.These schemes are characterized by the promise of high returns in a short period, an element that is often used to lure in more individuals. However, the nature of pyramid schemes dictates that eventually, it will become impossible to recruit new members and the flow of money will dwindle, thereby causing the scheme to collapse. Those who are at the bottom levels of the pyramid often bear the brunt of the financial loss when that collapse happens. It’s important to note that pyramid schemes are illegal in most countries due to their unsustainable and unethical nature.
Examples
1. Zeek Rewards: One of the largest pyramid schemes involved an American company called Zeek Rewards. It was an “investment opportunity” company which made its money under the guise of an internet advertising business. Investors were promised up to 1.5% daily ROI, based on the promise that they were buying into profitable online advertising. However, the returns were being paid from new investors, not profit. The company was ordered to pay a settlement of $600 million when it was discovered to be a scam in 2012.2. BurnLounge: The BurnLounge case is another popular example of a pyramid scheme. This US company marketed itself as a music download service where participants could earn money from not just their own sales, but also from sales made by people they recruited. The FTC shut down BurnLounge in 2007 for being a pyramid scheme, and it was held up as an example in court of how not all multi-level marketing businesses are legitimate. 3. Madoff Investment Scandal: While technically a Ponzi scheme, which is similar to a pyramid scheme, the Madoff Investment Scandal serves as a stark example of this type of fraudulent activity. Ran by Bernie Madoff, the operation promised unusually high and consistent returns to investors. However, no actual investment was made. The “returns” were paid out of the principal received from new investors. When Madoff was eventually unable to acquire new investments, the scheme collapsed. The scandal led to losses of approximately $64.8 billion, making it one of the most notorious pyramid-style schemes of all time.
Frequently Asked Questions(FAQ)
What is a Pyramid Scheme?
A Pyramid Scheme is a fraudulent investment strategy, in which participants are promised high returns for their investment. However, these returns are only possible through the recruitment of newer participants into the scheme. The scheme collapses when there are insufficient new recruits to keep it going.
How does a Pyramid Scheme work?
A Pyramid Scheme works by recruiting members with a promise of payment for enrolling others into the scheme. The initiator recruits new investors and takes the recruitment fee. These new investors then seek further recruits, whose fees are passed upwards in the scheme, benefiting those at the top.
Why are Pyramid Schemes illegal?
Pyramid Schemes are illegal because they rely solely on the ability to recruit more people into the scheme. This structure is unsustainable as it’s impossible to keep getting new recruits indefinitely. Eventually, the individuals at the bottom of the pyramid lose their investments, causing financial loss and hardship.
What’s the difference between a Pyramid Scheme and a legitimate multi-level marketing company?
The primary difference lies in their business model. Legitimate multi-level marketing companies derive the bulk of their profits from selling products or services, while Pyramid Schemes generate revenue primarily from the recruitment of new members or investors.
How can I recognize a Pyramid Scheme?
Several red flags may indicate a Pyramid Scheme: promised high returns on investment with little risk, compensation mainly based on recruitment rather than sales, pressure to recruit new members, and a lack of a genuine product or service.
What should I do if I encounter a Pyramid Scheme?
If you encounter a suspected Pyramid Scheme, do not invest any money or recruit others to join. Gather as much information as you can including any promotional materials, names, contact details etc, and report to your local law enforcement or consumer protection agency.
What are the repercussions of participating in a Pyramid Scheme?
Participants in a Pyramid Scheme not only risk losing their investment when the scheme inevitably collapses, but they may also face legal consequences. This is because the act of recruiting others into such a scheme is in itself illegal in many jurisdictions.
Can people make money off Pyramid Schemes?
Theoretically, people at the top levels of the pyramid can earn money – at least until the scheme collapses. However, for the vast majority of participants, especially those lower levels, financial loss is usually the outcome. It’s also worth noting that even for those who do profit, their gains come at the expense of others, and involves engaging in unethical and typically illegal activity.
Related Finance Terms
- Fraud
- Ponzi Scheme
- Direct Selling
- Recruitment
- Illegal Investment
Sources for More Information
- U.S. Securities and Exchange Commission
- Federal Trade Commission
- Investopedia
- Consumer Information – Federal Trade Commission
