What is a Pyramid Scheme?

Pyramid Scheme

A pyramid scheme is an unsustainable business model that involves promising participants payment or services, primarily for enrolling other people into the scheme, rather than supplying any real investment or sale of products or services to the public.

In a typical pyramid scheme, an individual or company recruits others to make an investment. Those initial investors are then instructed to recruit additional members, who also pay an upfront fee. The payments from the new recruits are used to provide the return on the investment for the original members.

Here’s a simplified example:

• Person A recruits two people (Person B and C), who each pay \$100. This money goes to Person A. So, Person A has now made \$200.
• Each of those two people (B and C) then recruits two more people. These new recruits each also pay \$100. Half of this money goes to their recruiters (B and C), and half goes up the chain to Person A.
• This continues, with each level of new recruits bringing more money into the scheme.

However, pyramid schemes are bound to collapse eventually. They require an exponential increase in participants to sustain the model, which becomes impossible to maintain as it grows larger. So while early participants can make a profit, those who join later typically lose their investments.

Due to their predatory and unsustainable nature, pyramid schemes are illegal in many countries, including the United States. They are often disguised as legitimate multi-level marketing (MLM) companies. While MLMs have a pyramid-like structure with their compensation plans, they are legal as they generate revenue through the sale of products or services, not solely through recruitment.

Example of a Pyramid Scheme

Let’s say John starts a new “investment company” and recruits ten friends (Level 1) by promising them a 50% return on their \$1,000 investment, which they will earn by recruiting new members.

Each of these ten friends (Level 1) recruits ten more people (Level 2), resulting in 100 new participants. Each Level 2 participant also invests \$1,000, which totals to \$100,000. This money is used to pay the promised returns to Level 1. So, each of the initial ten friends gets \$1,500 (their initial \$1,000 back, plus \$500 in “profits”).

Now, each of the 100 new people (Level 2) recruits ten more people (Level 3), resulting in 1,000 new participants. Each Level 3 participant invests \$1,000, which totals to \$1,000,000. This money is used to pay the promised returns to Level 2.

This recruitment and payout process continues until it’s impossible to recruit enough new members to pay the promised returns.

In our example, by the time it gets to Level 3, there are 1,000 participants who are each promised a return of \$500 (50% of \$1,000). So, \$500,000 in new investments is needed just to pay these returns. And to keep the scheme going, each of the 1,000 Level 3 participants would need to recruit 10 new members (10,000 new participants in total).

As you can see, sustaining the pyramid requires exponential growth, which eventually becomes impossible. When the scheme collapses (which it inevitably will), the majority of participants (those at the bottom of the pyramid) will lose their investments.

It’s important to note that pyramid schemes are illegal in many jurisdictions due to their deceptive and unsustainable nature. They often cause significant financial losses for participants, particularly those who join later in the scheme. Always be wary of “investment opportunities” that promise high returns with little risk and emphasize recruitment over product sales.