What Is a Pyramid Scheme and How Do They Work?

Pyramid schemes are an especially notorious form of "get rich" scams perpetrated by a small group of individuals who stand to gain the most financially. In a classic pyramid scheme, they are the "top of the pyramid" and get paid before other members of the scheme who stand lower on the pyramid.

The first pyramid scheme is credited to Charles Ponzi, who in 1919 engineered a "top down" scam involving promissory notes payable in 90 days and a promise to repay investors, at 50% interest, who invested in the notes. Ponzi, a Boston-based business man, was the first large-scale pyramid scheme originator who leveraged the cash of new investors (lower down the pyramid) to pay back old investors (higher up on the pyramid) until there were no new investors left, and the cash had dried up for good.)

Ponzi garnered $15 million from the scam, before being arrested and sent to jail, and eventually deported to Italy in 1934.

While law enforcement officials don't completely agree that a Ponzi scheme is technically a pyramid scheme, the two scams share basic similarities:

  • Both scams reward the early scheme participants and penalize the late arrivals.
  • Both scams require the oxygen of new cash to keep the scheme going - when the cash goes, the scam goes, too.
  • Both schemes are illegal and jail time for participants is commonplace.

There is one key difference between Ponzi schemes and pyramid schemes. Ponzi actually promised his investors a defined, clear-cut rate of return. With most pyramid schemes, investors aren't sure how much cash they're going to make - all they know is to keep recruiting other people into the scam and the money is supposed to follow.

How Pyramid Schemes Work

Pyramid schemes seem to start innocently enough. Often, it's friends, family or neighbors that begin the recruiting process, usually by engaging potential sales partners in person, over the phone, via email or online (especially on social media.)

Here's a brief step-by-step explanation on how pyramid schemes work.

Step 1: The originator

An individual or small group at the top of the pyramid scheme puts up a small amount of money, or in many cases, no money at all, for a get-rich-quick opportunity, then charges other members of the group to join. The idea is to sell a product or service, often of poor quality, or actually fake having a product or service, and convince outsiders to join in and charge them to do so.

Step 2: The "suckers"

Down the pyramid scale, newer investors plow money into a pyramid scheme, thus providing the cash needed to pay off the earliest investors. Financial accounts are created, profit statements generated, and checks cut to investors. At this point, all seems on the up and up, although not a single product or service has been sold to back up the investment - though investors don't know that yet.

Step 3: The collapse

Eventually, it gets more difficult to recruit new members into the pyramid scheme. When that starts happening, there is less money to pay back investors already involved in the pyramid scheme. When earlier investors in the scheme cash out, there's not enough money to pay off the rest of the investors at the bottom of the pyramid. When these investors try to cash in too, they find there's no money left to pay them, and the pyramid scheme collapses under its own weight.

In short, the idea with a pyramid scheme is to make your money not from a great product or service, but by recruitment - i.e., convincing others to pay money to participate in a "can't miss" money-making opportunity, then having those participants recruit other people to join, until there's nobody left to recruit and no more money to be made.

By that time, the pyramid scheme originators are likely long gone.

Examples of Pyramid Schemes

There is no shortage of real-world instance of pyramid scams in action. Consider these examples:

  • Wealth Pools. Back in 2007, a company called Wealth Pools International claimed to be selling foreign language DVD's through the company's network of sales representatives. In actuality, the firm was really paying its sales staff to recruit more sales reps, and wasn't actually earning any money on the DVD sales, making it a product-based pyramid scheme. The U.S. Security and Exchange Commission wound up freezing the company's assets, but only after scam participants lost $132 million of their own cash.
  • Fortune Hi-Tech Marketing. In this pyramid scam, Kentucky-based Fortune Hi-Tech Marketing claimed to act as a third-party marketing and sales arm of Dish Network, (DISH) the global satellite TV services provider, and for Frontpoint Home Security, a security products provider (along with several other companies.) In actuality, individuals who bought into the opportunity wound up making more money recruiting other sales representatives than they did selling satellite television or home security products. According to the U.S. Federal Trade Commission, over 350,000 were drawn into the pyramid scheme, paying up to $300 each annually to get the chance to lure other people into the scam. Fortune Hi-Tech was forced to pay back $7.7 million in penalties, and was barred by U.S. regulators from future multi-level marketing campaigns.
  • Social Media Pyramid Scheme. In 2017, a pyramid scheme bubbled up on Snapchat (SNAP) , where online users were urged to send a one-time joining fee, paid via Snapcash, Snapchat's online cash payments site. In doing so, they were promised to earn money every time a new user joined up and paid the fee. There was no product or service attached to the scam and users. Instead, "members" were urged to get the word out and recruit more people - usually teenagers - to earn their cash.

Multi-Level Marketing Companies Vs. Pyramid Schemes

Multi-level marketing companies - those that bring in sales associates and encourage them to recruit other sales associates to sell products and/or services - are actually different than pyramid schemes in one key way. They usually offer products or services that actually exist and are actually sold in the consumer marketplace.

That's a key distinction, as the law looks differently at companies who sell a concrete product or service, even if they use recruiting methods to rewards salespeople at the company. The problem with pyramid companies is that there is usually no product or service to sell - and that is against the law and is enforceable by state and federal government agencies.

That said, there are some similarities between multi-level marketing companies and pyramid schemes:

  • Both promise big profits if an individual pays and up and starts selling.
  • Both require upfront money, usually in the form of joining fees, inventory fees, and other upfront costs, with no guarantee you'll earn the money back.
  • Both usually ask for payment in the form of cash, wire transfer, money order, or online payment to join the "company."
  • Both can offer ample, hidden fees to either join up or keep selling for the company.
  • Both pay their sales associates more for the opportunity - and not for a product or service

The takeaway? If you're ever offered the opportunity to join any sales or marketing group where the emphasis is on recruiting to earn your pay, and not selling a product or service, you are likely joining a pyramid - with all the risk of financial loss that entails.

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