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A pyramid scheme is an illegal financial scam masquerading as a legitimate business. Pyramid schemes are similar to Ponzi schemes and multi-level marketing (MLM) companies, but there are important distinctions among these three structures.
What are the telltale signs of a pyramid scheme? Here’s a look at how pyramid schemes work, and how to tell them apart from an MLM or a Ponzi scheme.
What Is a Pyramid Scheme?
A pyramid scheme is a scam where a so-called marketing company promises to help you earn big profits in exchange for recruiting new participants into the scheme.
On the surface, a pyramid scheme appears to be a legitimate company selling products or services, but the core goal is always to grow the number of participants in the scheme rather than grow product sales. New participants are typically referred to as investors, salespeople, agents or distributors, or some variation on these titles.
In a legitimate business or an MLM, salespeople are compensated for selling products or services. The compensation structure tends to reward participants for recruiting an ever-growing number of new participants—not for growing product sales.
Typically, pyramid scheme participants are charged membership fees and commissions, and must buy set amounts of product inventory every month in order to remain in the company. Little attention is paid to actually marketing and selling products.
How Do Pyramid Schemes Work?
A pyramid scheme begins with one person or a small team recruiting participants to join a new business venture. The recruits are required to invest money into the venture, pay membership fees or purchase a certain amount of product each month.
The founders receive fees and sales commissions from the other participants, plus revenue from the sale of inventory. From that point on, successful pyramid schemes rely almost entirely on the continued acquisition and growing investments by an ever growing base of new participants.
The “pyramid” in the name comes from the structure of the scam, where one participant recruits several additional participants to work for them. These members then recruit more new participants beneath them … and so on.
The small number of participants at the top of the pyramid scheme make large amounts of money by harvesting commissions and fees from the layers of salespeople and distributors recruited to work below them.
“At the top of the pyramid, the founder or founders are essentially receiving fees from every participant below them,” said Jonathan Perlman, an attorney with the Miami law firm Genovese Joblove & Battista.