How to Avoid Pyramid Schemes

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Updated on Friday, October 25, 2019

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Direct selling can provide a flexible way for you to run your own sales business from home or online, but it’s important to distinguish legitimate companies from pyramid schemes. The red flag is when such a system depends on recruiting an ever-increasing number of “investors” than the selling of a product. We’ll help you avoid pyramid schemes and identify legal direct selling companies worthy of your research.

Direct selling vs. pyramid schemes

Direct selling is a legal business practice conducted through single-level sales (think door-to-door salesperson), host or party-plan sales and multilevel marketing companies, which depend on individual distributors to sell products to the public, often in a group, party-like setting or through catalogs or online stores. Distributors often have the opportunity to earn commission on their sales and those of the salespeople they recruit.

A pyramid scheme may be disguised as a multilevel marketing business, but it is actually an illegal scam that emphasizes recruitment rather than the sale of actual products. Instead of earning most of their income through selling, distributors are heavily rewarded for bringing on new sellers, who may have to pay an entry fee.

“It’s going to take some healthy skepticism and research for someone to recognize that difference,” said Stacie Bosley, associate economics professor at Hamline University in St. Paul, Minn.

As of 2018, direct selling represents $35.4 billion in retail sales in the U.S. and 6.2 million people work full-time or part-time in the industry, according to the Direct Selling Association. Continue reading to find out how to avoid a pyramid scheme if you’re thinking about pursuing a multilevel marketing opportunity.

What is a pyramid scheme?

A pyramid scheme can be defined as a company that requires participants to make an investment in the business in exchange for the opportunity to sell products to consumers. Oftentimes, sellers are highly rewarded for recruiting newcomers, who then make a similar investment in the company.

Many types of businesses provide rewards for referrals, giving customers a small incentive to suggest a product or service to others, Bosley said. But if the recruitment model is the central feature of the company, it may be a pyramid scheme.

“Look for a really strong pay-and-recruit structure,” Bosley said. “If that’s there, I would worry about its legality.”

How pyramid schemes work

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, who would also make a $500 investment in the business.

From there, she would earn $30 for each new member that her recruits bring on. 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.

There could be instances where legitimate companies follow a similar model of rewarding recruitment. But if new member recruitment earns you more money than selling actual products or services, then the company would likely be a pyramid scheme.

Why are pyramid schemes illegal?

Pyramid schemes are illegal because they defraud investors who are promised their money back. In reality, money from bottom-level investors is used to pay other investors farther up the pyramid. And products in these schemes are often unsellable.

Pyramid schemes took off in the U.S. in the 1970s. One-on-one selling became popular for consumer items, such as cosmetics, kitchen tools and branded items like Tupperware, and pyramid schemes took advantage of the trend. The Federal Trade Commission began cracking down on scams that emphasized networking over selling actual goods, and the organization has continued to monitor the direct sales industry.

Another wave of pyramid schemes swept through the U.S. in the 1990s with the rise of email and internet access. Such scams still pop up today, though the FTC continues to bring cases against deceitful companies.

“Fraud goes in cycles, just like economies,” said Cheryl Jarvis, marketing professor and department head at Florida Atlantic University in Boca Raton, Fla.

The problem with pyramid schemes is the people at the top of the chain are the only ones who make money, Jarvis said. The majority of participants don’t see a return on their investment and ultimately lose money. Pyramid schemes are often short-lived because eventually, distributors run out of people to recruit and the operation stops growing.

“Mathematically, they’re unsustainable,” Jarvis said.

Report suspicious behavior. In addition to the FTC, state agencies investigate pyramid schemes. For instance, any fraudulent activity in New York should be reported to The New York State Attorney General’s Office. You could also file complaints with the Better Business Bureau.

How to avoid pyramid schemes

In addition to an emphasis on recruitment, here are other indicators that a direct sales opportunity may be a scam.

It’s sold as a passive income or easy money opportunity. As a recruitment strategy, distributors often emphasize how little effort is needed to make an income. In any business, selling enough product to turn a profit takes hard work, so be cautious if the company makes it sound simple.

Promise of unrealistic returns in a short amount of time. If you’re earning fast cash despite low sales, you’re likely receiving returns on people getting recruited to the company. Generating revenue too quickly could be a red flag.

No buy-back system. Pyramid schemes and legitimate multilevel marketing companies both typically require new members to purchase product to sell to consumers. However, reputable companies should offer a buy-back option if you want to leave the business. A company that doesn’t refund members for unsold product may be a part of a pyramid scheme.

High upfront fees. Be wary if the buy-in fee or initial investment seems high or exceeds the value of the products. High upfront fees combined with the lack of a buy-back program could indicate the business is a scam. Legitimate direct selling companies have a median startup fee of $99, according to the Direct Selling Association.

Abstract language. Take note if the company is unclear about processes or structures within the business. Product descriptions, prices and claims may also be vague or questionable. Recruiters could make inflated income claims as well to attract new sellers.

Do your own research rather than relying on what you hear from distributors, Bosley said. They are incentivized to recruit you and may not objectively present information.

“Of course, scheme operators aren’t going to make it easy for you,” she said. “There are layers of rhetoric and that makes it difficult to see the bones of the scheme.”

One way to quickly check a company’s legitimacy would be searching the Direct Selling Association’s database. Although not all existing direct sales companies are listed, a company that is a member of the DSA could be considered a reputable multilevel marketing business.

How to say ‘no’ to a direct sales recruiter

Social media has become a conduit for pyramid schemes. When people are approached about multilevel marketing opportunities, the sales pitch is often coming from someone they know, which can make it difficult to turn down, Bosley said.

“There’s feelings of obligation, allegiance, [of] not wanting to let someone down,” Bosley said. “We underestimate how powerful those kinds of emotions can be.”

The person asking you to join the company could be unknowingly participating in a pyramid scheme. If you’re skeptical about the operation, it’s best to reject them outright in a way you feel comfortable, Bosley said.

“If you give them any room, their incentives just keep coming,” she said.

First, you should be honest about your suspicions that there may be something illegal in the structure of the company. You could take a more thoughtful approach, communicating that you’re concerned about their involvement and well-being. You may want to point out that they could potentially harm others in the recruitment process.

“It doesn’t just affect you; it affects the person who recruited you and it affects the people you pass it on to,” Bosley said.

Request documentation. You could then ask for company documents, such as marketing plans or audited financial statements. The recruiter may not be able to provide this information, but if they can’t get such forms from someone else in the company, you could use that as a reason to reject their offer, Jarvis said.

“Whenever you get strong-arm social pressure, I’d say that’s a red flag,” she said.

Pyramid schemes vs. multi-level marketing companies

If you’re considering getting into the direct sales industry, here’s how to spot a pyramid scheme compared to a multilevel marketing company.

MLM company

Pyramid scheme

Recruitment rewards may be offered, but product sales drive income.

Recruitment is the primary revenue driver.

Buy-back program and exit strategy available for sellers.

No repurchase plan for unused inventory.

Initial investment cost is relative to the value of products.

Steep fees to join the business and receive products.

There is an actual consumer demand for products.

Product descriptions and claims are vague or misleading.

When direct selling could pay off

Not all multilevel marketing companies are pyramid schemes in disguise. A direct sales business could have a lower startup risk and lower cost of entry compared to other business opportunities, like buying a franchise, said Joseph Aquilina, ethics and compliance counsel for the Direct Selling Association. Although the payoff could be miniscule — as low as 70 cents or less per hour — sellers are usually independent contractors and can work on their own schedule.

“This is a very low-cost and low-risk opportunity for people to build their own businesses,” he said.

People often fall prey to pyramid schemes because of a need to supplement their household income, Aquilina said. While direct selling could provide a solution, scams and illegitimate businesses could turn people off the entire industry.

“It can take only a few bad apples to present a reputation challenge for the whole bunch,” he said.

You could also start a hobby-based business to monetize a personal interest. You would be able to follow your entrepreneurial instincts without answering to a larger organization. But getting a business up and running — and reaching profitability — takes time and commitment, even more so than direct selling.

Keep in mind that multilevel marketing depends on sales, and you have to be willing to put in effort to become successful, Jarvis said. Chasing a quick-fix or easy way to make income would likely land you in a pyramid scheme rather than a legitimate company.

“You’re going to be spending a lot more time than you think to make sales,” she said. “Those who are successful are the ones who make it a full-time job.”

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