How Pyramid Schemes Work

Sergei Mavrodi leaves prison in May 2007. MMM, the pyramid scheme Mavrodi founded, defrauded more than a million Russians in the 1990s. See more money scam pictures.

You're outside cutting the lawn and your neighbor pulls up in a brand-new BMW. He's wearing a suit and carrying a briefcase. You've never seen this guy out of his sweatpants. Maybe a millionaire uncle died?

After some small talk, you ask him what's up with the new car and the new suit. He acts all coy and says he just got lucky with a new type of business opportunity. You're curious, so you ask for more details.

He says he's become a freelance distributor for a health supplement company. Turns out that there are tons of people out there who will pay big bucks for his products. And even better, the more salesmen he hires to work for him, the more money he makes. For a one-time sign-up fee, plus the cost of the merchandise, you could start doing the same thing tomorrow. "Hire 10 salesmen," he says, "And you'll have your own BMW in a month."

Wow, you think, this is the real deal. No more office work, no more bosses, just managing a team of salesmen from home. You go for it. You hand your neighbor a check, collect your starter kit of supplements and start hitting the phoneslooking for potential salesmen.

You call your buddy Bob to see if he's interested. But the weird thing is, Bob ran into your same neighbor yesterday at the grocery store and also signed up to be a distributor. What's worse, Bob's already been calling around, and it looks like your neighbor and his buddies have already signed up half the city.

"Nobody's going to want to buy from us because we're all trying to sell!" cries Bob. "And we'll never make our money back on salespeople because there's no one left to recruit!"

Looks like you've been suckered in by a pyramid scheme. Your neighbor and his buddies are at the top of the pyramid. They got in early and made money by recruiting people like you. But now you're competing with hundreds of other distributors for the same small pool of potential recruits. The odds of making your money back are worse than roulette in Vegas [source: Taylor].

So who makes money and who loses it in a pyramid scheme? And what are some signs that a fabulous "business opportunity" is really a pyramid in disguise? Read on to find out.

1. What is a Pyramid Scheme?
2. Multi-Level Marketing and Pyramid Schemes
3. Famous Pyramid Schemes
4. How Pyramid Schemes Work: Author’s Note
5. Pyramid Schemes: Cheat Sheet

What is a Pyramid Scheme?

Pyramid schemes quickly become unsustainable.

The main characteristic of a pyramid scheme is that participants only make money by recruiting more members. There are many different kinds of pyramid schemes, but the two most basic are product-based and so-called naked pyramid schemes.

In a naked pyramid scheme, no product is sold. Here's how it works:

1. One person recruits 10 other people to participate in a "no-fail investment opportunity."
2. The 10 recruits each pay the recruiter $100.
3. The recruiter now tells them to go out and recruit 10 more people to do the same.
4. If each recruit is successful, they'll all end up with $900 in profit from a $100 investment.

Sounds simple enough, but here's the problem: Let's say the initial 10 recruits each find 10 more people. Those 100 new recruits will have to find 10 recruits each to make $900. That means they have to find 1,000 people willing to sign up for the program. And if they somehow find 1,000 people, that next level of the pyramid will need to sign up 10,000 to make a profit. Eventually, there won't be enough recruits at the bottom of the pyramid to support the level above it. That's when the pyramid topples and everyone at the bottom loses their investment.

A product-based pyramid scheme is the same concept disguised as a legitimate direct sales opportunity. Here's how it works:

1. A distributor recruits 10 salespeople who each pay $500 for a starter kit of products to sell.
2. The distributor gets 10 percent of each starter kit that's sold.
3. The distributor also gets 10 percent of each product that any of his recruits sells, including more starter kits.
4. The recruits are told that the fastest way to make money isn't by selling products, but by recruiting more people to buy starter kits.
5. The people at the top of the pyramid get commissions from everyone in their downline, the many levels of recruits below them on the pyramid.

The problem with most product-based pyramid schemes is that the products themselves don't sell very well, or have very slim profit margins. So the only way to make money is to find more recruits. Eventually (and surprisingly quickly), the market becomes saturated. There are too many people trying to sell the same unattractive product and there's no one left to be recruited.

It's mathematically impossible for everyone to make money in a pyramid scheme. For example, if each recruit needs to find 10 more people to recoup the cost of his or her initial investment, the eighth level of the pyramid would have to recruit a billion people to make back their money. And the next level would need 10 billion, nearly twice the population of the Earth.

In fact, pyramid schemes don't work unless somebody loses. Those at the bottom of the pyramid are essentially defrauded by those on top. It's a mathematical fact that no matter how many people join a pyramid scheme, 88 percent of the members will be on the bottom level and will lose their money [source: Pyramid Scheme Alert]. Pyramid schemes are illegal because people don't lose their money due to normal market forces, but because the system requires them to lose so that a few at the top will win.

Studies show that in a naked pyramid scheme, 90.4 percent of people lose their money, while in product-based pyramid schemes, that number jumps to a shocking 99.88 percent [source: Taylor].

So what's the difference between product-based pyramid schemes and legitimate multi-level marketing (MLM) companies? Or is there even such a thing as a legitimate MLM? Read on for more info.