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How Do Pyramid Schemes Work: What Makes Them a Deceptive Business Model?

A pyramid scheme is a fraudulent business model that seeks to funnel revenue from recruited members to the scheme’s organizers by promising payments to members for recruiting new participants. Although pyramid schemes promise large, quick returns, they inevitably fail, causing most members to lose their investments. The word pyramid reflects the model’s structure—a leader or small group of organizers at the top of the scheme and an increasingly broad base of members below them. Forming or recruiting for pyramid schemes is illegal in the United States and in many other countries and jurisdictions.

Defining a Pyramid Scheme

A pyramid scheme is a fraudulent and unsustainable investment pitch that relies on promising unrealistic returns from imaginary investments. The early investors actually get paid those big returns, which leads them to recommend the scheme to others. Investors' returns are paid out of the new money flowing in. Eventually, no new investors can be found and the pyramid collapses.

In a variation of the pyramid scheme, investors at each level charge initiation fees that are paid by the next layer of investors. A portion of those fees is paid on to those in the top layers of the pyramid. Eventually, no one is left to recruit. The pyramid collapses.

Often called pyramid scams, these operations are illegal in the U.S.

How Pyramid Schemes Work

Pyramid schemes are so named because their compensation structures resemble a pyramid. The scheme starts with a single point on top where the original members exist and becomes progressively wider toward the bottom as people are recruited by every level of recruits.

In a pyramid scheme, an organization compels individuals who wish to join to make a payment. In exchange, the organization promises its new members a share of the money taken from every additional member that they recruit. The directors of the organization (those at the top of the pyramid) also receive a share of these payments. For the directors, the scheme is potentially lucrative—whether or not they do any work, the organization's membership has a strong incentive to continue recruiting and funneling money to the top of the pyramid.

Such organizations seldom involve sales of products or services with value. Without creating any goods or services, the only revenue streams for the scheme are recruiting more members or soliciting more money from current members. The behavior of pyramid schemes follows the mathematics concerning exponential growth quite closely. Each level of the pyramid is much larger than the one before it. For a pyramid scheme to make money for everyone who enrolls in it, it would have to expand indefinitely. When the scheme inevitably runs out of new recruits, lacking other sources of revenue, it collapses. Since the biggest terms in this geometric sequence are at the end, most people will be in the lower levels of the pyramid; accordingly, the bottom layer of the pyramid contains the most people. The people working for pyramid schemes try to promote the actual company instead of the product they are selling. Eventually, all of the people at the lower levels of the pyramid do not make any money; only the people at the top turn a profit.

Distinguishing Pyramid Schemes from Legitimate Business Models

A Ponzi scheme is a type of pyramid scheme that pays investment returns to an initial group of investors through funds secured from investors who join later. In contrast, multilevel marketing (MLM) models (also called network marketing) differ from pyramid and Ponzi schemes in that members make money primarily through the sale of actual goods and services and not from recruiting new participants.

Pyramid schemes are deceptive and illegal business models that prey on the hopes and dreams of individuals looking for quick financial gains. While they may seem enticing at first, the reality is that the vast majority of participants end up losing money. It's essential to be informed and cautious when approached with any investment opportunity that seems too good to be true.

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