How to Spot a Pyramid Scheme: 5 Red Flags to Avoid

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Updated on Tuesday, July 6, 2021

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A pyramid scheme is a type of scam where participants pay to join a business and can make money by convincing others to “invest” in the opportunity. The people recruiting you will often promise that you’ll receive something greater than what you put into the opportunity yourself.

It’s often difficult to tell the difference between a pyramid scheme and legitimate multi-level marketing (MLM) business because, in many ways, the two are similar. So, it’s important to be on the lookout for red flags. Companies that focus heavily on new member recruitment over product sales may claim to be MLM companies, but they are often pyramid schemes in disguise.

How does a pyramid scheme work?

A pyramid scheme is a type of investment scam that may rely on individual distributors to sell its products to the public. To become a distributor (sometimes called a consultant, retailer, or contractor), you must pay a fee or perhaps purchase a supply kit to get started. You may then earn commissions when you recruit additional sellers who pay an entry fee themselves or when those investors purchase inventory to resell.

Here’s an example of a formula that a pyramid scheme could follow. Let’s say a seller makes a $500 investment to join the business. She is told she would be rewarded $150 per person if she recruits three more sellers (aka her downlines), who would each make their own $500 investment in the business.

From there, she would earn $30 for each new member that her recruits bring on (aka her second-level downlines). All of her recruits are given the same offer.

The original seller stands to make an increasing profit on her $500 investment, depending on how many people her recruits bring into the company. But each new member would make $450 at the first level, $50 short of their break-even point if they only recruit three more people. If they can’t pass the first level, they won’t get a return on their investment. Meanwhile, the company would continue to collect $500 from every new recruit, although it would have to pay commission to those who recruit more new members.

Why are pyramid schemes illegal?

Pyramid schemes are illegal in the United States because they are scams at heart. They promise investors their money back (and often huge multiples of their initial investments), but they fail to deliver. In reality, they are not legitimate investment opportunities. It’s the founders of these schemes, and top-tier management, who generally profit off the investments of lower-level sellers.

Dr. Stacie Bosley, associate professor of economics at Hamline University, says the key is that pyramid schemes aim to deceive.

“The vast majority of people are likely to lose money by design, and so for that reason it’s considered a deceptive tactic and is illegal,” says Bosley.

Both the Securities and Exchange Commission and the Federal Trade Commission enforce laws pertaining to pyramid schemes. You can report suspected pyramid schemes to either law enforcement agency via the links below:

You can also report suspicious activity to your state attorney general.

Bosley cautions that pyramid schemes involve a different type of risk than you might encounter in other fraudulent schemes.

“If you think there’s a chance that something might be a pyramid scheme then you owe it to yourself and to others that you care about to stop and assess the situation,” she says. “The risk isn’t just to you. It’s also to your family and your social circle.”

5 ways to spot a pyramid scheme

Before you sign up for any direct selling opportunity, you should keep an eye out for the following red flags that could indicate it’s a pyramid scheme.

  1. It’s sold as guaranteed passive income or an easy money opportunity.
    Pyramid scheme participants often present their companies as opportunities to make more money with little effort on your part. Some may even suggest that you’ll earn passive income without having to do any work yourself. In reality, selling enough products to turn a profit takes hard work in any business.
  2. There’s a promise of unrealistic returns in a short amount of time.
    You should be wary of any company that promises you high monetary returns on your investment in a short period of time. And if the promised returns are tied to recruitment rather than product sales, it’s a double warning sign.
  3. You have to pay high upfront fees.
    If the initial investment or buy-in fee is higher than the value of the products or inventory you’ll receive, the opportunity could be a pyramid scheme. According to the Direct Selling Association, the median cost to purchase a start-up kit with supplies, samples and materials to help you sell products is just $99.
  4. There’s no buyback system.
    It’s not unusual for multilevel marketing (MLM) companies to require their new members to purchase products they will resell to consumers. Reputable companies should offer to buy back the product, however, should you wish to leave the business. A company that doesn’t offer a system to buy back unused products may be a pyramid scheme posing as an MLM.
  5. The explanation of the opportunity contains abstract language.
    The compensation schedules of pyramid schemes are often complex, and may contain abstract language that confuses you. “Don’t put your money in something you don’t understand,” Bosley says. “And don’t be embarrassed about it. It may be complex or misrepresented so it’s confusing by design.”

Pyramid scheme vs. MLM

The lines between a pyramid scheme and a multilevel marketing business can often blur. Yet the main differentiator between the two comes down to recruitment. If the primary way you make money is by getting others to pay to sign up under you, then the opportunity is probably a pyramid scheme.

“The moment recruitment becomes part of the job description is a moment to pause,” says Bosley.

Joseph N. Mariano, president of the Direct Selling Association, also cautions consumers against signing up for recruitment-focused opportunities. When you’re trying to tell the difference between a pyramid scheme and an MLM, Mariano says “ensure the company is product-focused and not based primarily on recruiting new team members.”

Here’s a side-by-side comparison to help you tell the difference between a multilevel marketing company and a pyramid scheme.

 

Pyramid scheme

MLM company

How you make moneyThe company rewards you more for recruiting new participants than it does for selling products to customers.Product sales are the primary way you earn money (though recruitment may still be a part of the compensation structure).
What happens to unsold inventoryThe company won’t buy back unused inventory.The company offers a buyback program and exit strategy for sellers.
What it costs to joinYou must pay a high buy-in fee to participate.The initial investment cost makes sense based on the value of the products you receive.
Product offeringsThe company’s product descriptions and claims are misleading, confusing or vague.There’s genuine consumer demand for the products the company offers.
ResourcesThe company doesn’t seem concerned about helping you sell the product.You will receive training or marketing materials to help you sell the product.

When direct selling could pay off

In 2020, there were 7.7 million direct sellers in the U.S., according to the Direct Selling Association — 900,000 full time and 6.8 million part time. According to Mariano, most of those direct sellers or independent contractors are “microentrepreneurs who are interested in earning a modest supplemental income sharing and selling the products and services they use and love.”

Yet despite the popularity of MLMs, numerous experts and studies suggest that most participants either earn very little, lose money or break even.

  • A MagnifyMoney survey found that most MLM participants earned just $0.67 an hour — and that’s before deducting business expenses.
  • An AARP survey found that only 25% of people who join multilevel marketing companies reported earning more than they invested in the business.

To be fair, there are some individuals who are successful at legitimate direct selling. But these people tend to dedicate a lot of time and energy to sales, approaching the opportunity like a full-time job or small business. If you expect to put in little to no effort and reap big financial rewards, you’ll almost certainly lose your initial investment and be disappointed in the results.