Pyramids Are Buildings, Not Businesses

April 14, 2006 — -- Author's note:
A new crop of college seniors is about to graduate. As they start making real money for the first time in their lives, they are prime targets for scam artists. Scammers tend to target young people who haven't heard about their dirty tricks yet, and older people who've forgotten! So, for the next few weeks, I want to devote my column to some of the classic scams we all need to be aware of.-- EL

A pyramid is a sound structure for a building but not for a business. And yet thousands of people have lost millions of dollars on pyramid schemes. The most basic pyramid scheme is the old chain letter. You know, you receive a letter (or e-mail) containing a list of names. You're asked to send a dollar to the name at the top of the list. Then you're supposed to cross that name off, add your own name to the bottom of the list and send the letter on to 10 friends. Theoretically, if your friends do their part and pass the letter (and cash) along, eventually your name will be at the top of the list and you'll receive all sorts of money from strangers.

Bull! First of all, these chains usually break after just a couple of rounds. Secondly, they are just transfer schemes to move money from the bottom to the top of the pyramid. And third, they're illegal. Chain letters are easy to spot. But many illegal pyramid schemes disguise themselves as businesses, especially multilevel-marketing businesses.

Here's the key. In legitimate multilevel marketing, sales reps make money when they sell products and when reps they've recruited sell products. In an illegal pyramid scheme, sales reps make money when they recruit new reps and when the reps they've recruited recruit still more reps. Now here's the rub: Today more and more pyramids trick people by coming up with a product to use as a false front.

I once investigated a company that claimed to be a multilevel-marketing business selling Internet service. I arranged for an undercover producer -- and three hidden cameras -- to hear the pitch. The salesman didn't know much about the Internet service he was supposed to be selling, and that was our first clue. He couldn't even remember how much it cost a year. Next, the salesman told our producer he would have to pay $295 to come work for the company. That was red flag No.2. Legitimate companies don't charge you to work for them.

The salesman said it was possible to gradually make money by selling the Internet service, but he made it clear that the real money was in recruiting and training other sales reps. That's the hallmark of a pyramid scheme: making money through recruitment. Furthermore, the company structured that recruitment rigidly. Each new rep had to recruit two more reps who in turn had to recruit two more and so on. If you draw a diagram of the recruiting structure, guess what it looks like? A pyramid.

The salesman claimed some of his colleagues were making $25,000 a week. He said the company was making $500,000 a month. Grandiose claims about earnings potential are another classic pyramid tactic. But get this: When I confronted the company and asked if the Internet service was up and running yet, the salesman admitted it was not. If there was no product to generate all that profit, where was the money coming from? Well, it was coming from the poor recruits. Remember, each one paid $295 to join the company. It was a pyramid scheme and it collapsed soon after my investigation.

The government has struggled to define pyramid schemes and prosecute the perpetrators. Here are two tests investigators have come up with. The sales reps must make substantially more money from selling the product than they do from recruiting new reps. And they must sell the product to people outside the company who actually use it. Here's the most insidious thing about a pyramid scheme: Even though you are a victim of the people above you in the pyramid, you can be prosecuted for taking advantage of the people below you.

Here's another way to think about it: Pyramid-shaped business plans are mathematically doomed to failure. It's called exponential expansion and it's impossible to sustain. Let's take a two-by-two scheme like the one I investigated. Every rep has to recruit two more reps, who have to recruit two more, and so on. After just 33 levels of recruitment, they will have used up the entire population of the planet. There won't be anybody left to recruit.