Business

Pyramid Scheme VS. MLM

Has one of your friends started pushing beauty products on Facebook?  Were you invited to a casual party and then shown a bunch of candles that the host hoped you would buy?

Scenes like this are frequently becoming more and more commonplace as thousands of people who are looking to start a side hustle are signing themselves up to become sales representatives for something called an MLM distributor.  

MLM stands for multi-level marketing and it is a form of network marketing that allows people to make commissions from selling products.

The idea is simple: share products with friends and family, get them to buy the items, and then the MLM company will pay you a cut.  Easy as that, right?

You might be thinking: Wait! I’ve heard about businesses like this before.  Aren’t they all a scam?

The reality is that it depends on who you ask.  For many people, including the companies who run them, the lines between what’s legitimate and what’s not can be a bit blurred. There are tons of multi-level marketing companies out there, such as OPTAVIA, Young Living, and Mary Kay, and the list goes on and on. With such a vast amount of MLM companies, how do you know which ones are legit and which are pyramid schemes?

In this post, we’ll explore the differences between MLM companies and pyramid schemes, and show you how you can safely spot one from the other.  

pyramid scheme

What Is An MLM?

Multi-level marketing or MLM is a type of business where the company (or distributor) will use independent representatives to sell their products direct to consumers.  Each sale will result in the representative being paid a commission.  Therefore, the more sales they make, the more money they’ll earn.

For example, if you work with an MLM company that sells makeup products, you may get a 10% commission any time you sell one of the company’s products. If you make a $100 sale, you get to keep $10.

It’s very common for people, particularly young women such as stay-at-home moms, to get involved with MLMs.  According to a study by the AARP: Roughly 1 in 13 Americans have participated in an MLM organization at some point during their lifetimes.

Recruiting

One of the most questionable elements of MLMs is the practice of recruiting.  

Typically, recruiting works when an existing representative will convince another person to also become a representative.  When they do this, the existing representative will then receive a percentage of the new representative’s commissions.  The new representative will then also try to recruit other new representatives in hopes of getting some of their commissions, and so on.

Remember our example above? You sold $100 worth of product and made a $10 commission (10%). If you were to refer a new person to the program, you may also get 1% of their sales. In this case, you would make a 10% commission on the products you sell ($10 on a $100 order) and 1% on the products your referral sells (1$ on a $100 order).

This is why people who are involved in multi-level marketing schemes like to recruit new members. As an MLM distributor, you can make money from:

  1. Selling products
  2. Recruiting new distributors who sell products

Some MLMs with sketchy recruiting practices have even been accused of creating high-pressure situations to recruit new representatives.  The existing representatives will often try to persuade potential new recruits not to “miss out on an opportunity of a lifetime” and will paint a picture of how easy it is for them to make a ton of money.  However, their motivation is not for the well-being of the new recruit; they simply just want to increase their earning potential by bringing in as many recruits as possible.

Now that we know how MLM businesses work, let’s take a look at pyramid schemes.

What Is A Pyramid Scheme?

On the surface, a pyramid scheme has a lot of similarities to an MLM.  They both have hierarchal structures that look like a (you guessed it) pyramid.

What Is A Pyramid Scheme

With a pyramid scheme, the entire scheme is built around recruiting new members (building the pyramid). If new members are not recruited, the pyramid scheme is exposed and the pyramid comes crashing down.

Pyramid schemes are not legitimate businesses. Even if there is a business component, it’s secondary to the scheme itself.

Pyramid schemes have different tiers, and the people at the top benefit the most.

Let’s look at a hypothetical example.

John recruits you for his cleverly disguised pyramid scheme. You agree to pay him $100 for the privilege of being recruited. As a recruit, you are able to recruit more people. Every person you recruit pays you $100, of which you get to keep $95 and John gets to keep $5. If you recruit 10 people, here’s how it looks:

  • John Makes $150 – Your initial $100 + $50 from your recruits( $5 x 10)
  • You Make $850 – $950 from your 10 recruits minus the $100 you paid John

While the numbers may look good at first glance, there are two main issues:

  1. The numbers are completely manufactured – This isn’t business. Nothing of value is being exchanged. It is an unethical scheme.
  2. You are unlikely to recruit 10 people – In the example above, you made money because you recruited 10 people. In real life, you are unlikely to recruit anyone, meaning you would lose your initial $100.

So, how does this all relate to MLMs? Let’s take a closer look.

Are MLM’s And Pyramid Schemes The Same Thing?

MLM’s and pyramid schemes are similar, but there is one key difference:

  • MLMs are legal
  • Pyramid schemes are not

In most instances, the line will be in how they handle their recruitment process.  At their extremes, a lawful MLM will focus on promoting quality products and only use recruitment incentives to supplement your commissions.  On the other hand, a pyramid scheme will generally offer low-quality products (or sometimes no product at all), try to get your money up-front, and then encourage you to make your money back by recruiting other people (so that you can take their money instead).

If that sounds a little confusing, then you’re not alone.  There is a lot of grey area in-between these two extremes, and as a result, many MLM companies have been publicly accused of illegal practices.  

Perhaps one of the most recent and notable companies to be accused of being a pyramid scheme was the supplement business Herbalife back in 2011.  When the FTC got involved, they found that many of the representatives were only making a startling $5 per month.  In 2016, the company settled the case for $200 million.

Pyramid Scheme Lawsuit

The difference between pyramid schemes and MLM companies often comes down to the underlying business. Let’s take a closer look.

Are MLMs Legitimate?

When done responsibly, an MLM venture should be just like any other sales business. The representatives do all the legwork of directly selling the products, and then earn commissions for their sales.  In truth, that’s really no different than the arrangement of millions of people who work in sales earning commissions as a full-time career.  

While a pyramid structure may be a red flag, many completely legitimate businesses operate with similar structures. For example, by the time you purchase a product in a store, multiple parties have made a profit off of it. The manufacturer sells it to a wholesaler who sells it to a store that sells it to you. That’s how business works.

The problem with MLM’s is that they tend to operate under shady principles.

The reality, unfortunately, is that the grand majority of people who participate in MLMs never end up making any money at all.  According to the FTC (Federal Trade Commission), a sobering 99% of those people who get recruited end up losing money. 

mlm scheme 03

Here are some litmus tests you can use to differentiate between a legitimate business opportunity and a fraudulent scheme.

Does The Business Make More Money From Selling Products or From Recruiting?

We mentioned earlier that MLM participants can make money in two ways:

  1. Selling product
  2. Recruiting new MLM participants

The former is a legitimate business practice, while the latter can be a sign of an MLM scheme or a pyramid scheme.

Ask yourself, “are people buying this product because they want the product or because they want to be a part of the MLM business?

If people are only buying the product to join the MLM, it is probably not a legitimate MLM company (and could be an illegal pyramid scheme).

Are the Recruitment Methods Ethical?

Legitimate businesses use legitimate practices to recruit. While they may pitch some of the perks of the business, they will keep their claims grounded in reality.

For example, when you sign up for a business school, a legitimate school will not lure you by pitching pipedreams of becoming a millionaire.

When you get a new job, the recruiter is unlikely to make false claims about how you can “make bank” and retire early.

Many MLM recruiters make bold claims and try to trigger an emotional response. The pitches can be convincing. They will explain how you can make thousands of dollars per month by simply recruiting a few new participants.

If it seems too good to be true, it likely is.

How To Spot A Pyramid Scheme

Is someone trying to get you involved with an MLM?  Here are several tall tale signs that it might actually be a pyramid scheme in disguise: 

  • Have you never heard of the product or can’t find out any information about it?  Is there not actually any market demand for it?  
  • Do you have to buy your own inventory and are stuck with it if you don’t make any sales?  
  • Are you being charged a fee to become a distributor?
  • Do the recruitment practices seem very high-pressure?  Are you being told you’ll make unbelievable amounts of money?  Does a large part of that money depend on you finding other recruits?

If the answer to any of these questions is even a hint of “yes”, then beware.  You might be being preyed upon by a pyramid scheme.  

Before signing up with any MLM, always investigate them first with the Better Business Bureau. You may also check to see if they have any outstanding cases with the Federal Trade Commission.  Check around for reviews of the products that the company offers.  If they’ve got generally poor ratings, then that should be a red flag.

Also, never let them convince you that you are “missing out” on an opportunity.  When someone is doing this, they need you more than you need them.

Kevin Martin

Kevin is an ambitious entrepreneur that is obsessed with all things related to finance. From a young age, Kevin has always been involved with side hustles ranging from online selling to freelance work. Over the years, Kevin graduated from side hustles and started launching multiple online and offline businesses. Kevin is a serial entrepreneur who loves starting new businesses and exploring all things related to business and finance. He is constantly looking for new ways to save money, invest money, and create income streams.

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