What Is the Difference Between Multi-Level Marketing and an Illegal Pyramid Scheme?
The following exchange may sound familiar: you receive a message on social media from an old classmate (or an acquaintance you haven’t heard from in years) out of the blue. After a few pleasantries, they hit you with the real reason they’ve reached out: They have a fabulous business opportunity they want to tell you about. It’s changed their life, giving them the freedom to be their “own boss” and make enough money to pay their bills, take vacations, and any number of other wonderful things.
It might turn out that your “old friend” is involved in a multi-level marketing (MLM) business. In some cases, the “business opportunity” is actually an illegal pyramid scheme. The Direct Selling Association reports more than $35 billion in direct retail sales in 2018, with more than 6.2 million Americans working as direct sellers.
Becoming involved with an MLM company might seem appealing initially, but before you sign up, you need to do your homework. Not only is there a chance you may fail to make money with MLM schemes, but if you get involved in a pyramid scheme, you could land in legal hot water yourself.
What Is Multilevel Marketing?
At its most basic level, MLMs involve individuals selling products directly to other individuals. To get involved you typically purchase a “business startup kit,” or similarly named package, which usually contains sample products, catalogs, order forms, business cards, and other marketing materials. From there, it’s your responsibility to sell products, often by scheduling home meetings or demonstrations. Because working for an MLM in this capacity is typically considered contract work, representatives do not enjoy the full array of legal protections full-time employees are entitled to.
MLMs typically have complex commission structures that rely on your ability to recruit others to become distributors as well. Although in a true MLM you can earn some commissions on just your sales, the highest earnings usually come in when you have an extensive “downline.” When you recruit people to be a part of your team, you earn a portion of their commissions on sales, and a higher rate on your own sales. MLMs also allow their distributors to purchase products at a discount.
MLMs often use attractive incentives to encourage their distributors to sell and recruit as much as possible. Cash bonuses, lavish vacations, new cars, and more may be available to those who reach the highest levels within the company. Earning these bonuses usually means selling thousands of dollars in product and recruiting dozens of additional sellers. Unfortunately, according to an AARP study, the majority of MLM sellers never achieve this level, with more than half of participants noting that representations of financial success were inaccurate.
That assessment likely stems from the fact that 47% of MLM participants actually lost money from their involvement. In addition to the initial sign-up fees, many MLM distributors incur out-of-pocket expenses to keep their businesses going. For example, some companies offer a free personalized website where customers can place orders directly on a trial basis. Once the trial ends the company charges a monthly maintenance fee. Distributors may also be required to purchase new catalogs as they are released, new inventory to show as older items are discontinued, or to attend costly training or education sessions.
What Is a Pyramid Scheme?
Because pyramid schemes share many similarities with MLMs, the distinction can be unclear to those not familiar with these types of operations. Ultimately, the primary difference between a pyramid scheme and an MLM is the sale of tangible products. With an MLM, it is possible for participants to earn money from sales without any requirement to recruit others. With a pyramid scheme, recruiting others as part of your downline is a requirement for earning any money, regardless of whether any physical products are sold.
Consider a traditional pyramid scheme: Person 1 establishes a “club” that requires a $1,000 buy-in, with the promise that anyone who buys in will earn 10 times their investment. Five people give Person 1 the fee, and are then responsible for recruiting 10 more people to buy into the club at $1,000 each, with a portion of those fees going to person 1. Each of those people then needs to recruit 10 people to join, and so on.
Ultimately, the individuals at the bottom of the pyramid make less than those at the top, because an ever-increasing portion of the buy-in fee is going to those at the top of the pyramid. Eventually, the entire scheme collapses when it becomes impossible to recruit new members to the “club.” The founder of the scheme walks away with a large sum, while the bottom of the pyramid loses money.
Another variation of this scheme does involve the sale of products. However, instead of a distributor serving as a middleman to sell products to individuals, the distributors are required to purchase a predetermined amount of product to sell directly to customers however they see fit. In theory, they recoup their investment by selling the products. Typically, though, earnings come from recruiting others to join and purchase products.
According to the Federal Trade Commission, there are clear signs that an opportunity is a pyramid scheme, not a MLM.
- An emphasis on recruiting, with the majority of your earnings potential tied to how many people you get to join;
- Promises of a much higher-than-average return on your investment in a short time;
- No tangible products to be sold, or requirements to purchase large amounts of inventory;
- Ongoing requirements to purchase inventory or products you do not need or want;
- Promises of “easy money,” or significant earnings with little to no work.
- No demonstrated earnings from retail sales.
There are multiple types of pyramid schemes, such as Ponzi schemes. This type of scheme uses investments from the downline to pay big dividends to existing investors using the funds from new investors.
Why are Pyramid Schemes Illegal?
Pyramid schemes tend to run afoul of consumer protection laws, and are illegal because they rely on fraudulent and misleading claims to operate, and ultimately they become unsustainable. Pyramid schemes all but guarantee people on the bottom of the scheme will lose money, some even to the point of needing to declare bankruptcy. Depending on how the scheme is conducted, it may be investigated and prosecuted by any number of agencies, including the FTC, the SEC, the FBI and the U.S. Postal Service.
How to Report a Pyramid Scheme
If you’re approached to join a pyramid scheme, reporting it to the authorities can protect others from being taken advantage of and losing money. Begin by reaching out to your state attorney general. By visiting your state’s official website, you can find the specific instructions for contacting the local AG office. After that, consider reaching out to:
- The Federal Trade Commission. Visit gov and click on the tab for “Eduction, Jobs, and Making Money.” From there select the link to “Multilevel Marketing and Pyramid Schemes” and follow the prompts to make your complaint.
- Securities and Exchange Commission. The SEC website has an online portal where you can submit tips related to pyramid schemes.
- If the pyramid scheme involves the U.S. Mail, you can report it to the USPS Inspection Service, using the online form on the United States Postal Inspection Service website.
Is a MLM Venture Right for You?
Although there are plenty of MLM businesses that are legitimate and present real opportunities to make money, signing up may not be a wise investment. Aspiring entrepreneurs would do well to get familiar with basic business laws that can help them understand when a given business model may be unsustainable or makes fraudulent claims about income and potential for success. Unless you are fully committed to sales and willing to put forth an effort to market and sell the products, it’s unlikely that you will make a significant income. Going in with reasonable expectations is key to preventing (or reducing) losses. This means setting realistic sales goals, a plan for promoting the products, a commitment to devoting a sufficient amount of time to the business, and a willingness to accept that you may lose time and/or money.
With that in mind, before signing up for an opportunity, keep these tips in mind.
- Do your homework. Check out the company and research their reputation with the Better Business Bureau, past distributors, and customers. What do people think of the company and its products?
- Evaluate the products. Are the products something that will actually sell? What is the market? How many other distributors are already serving your market? Do the products have a positive reputation with customers?
- Consider the total costs. Some MLMs will entice new distributors with special offers to sign up for a minimal investment, but will hide associated costs in the fine print. Fees for marketing materials and websites, training or seminars, purchase minimums, and return policies should be clearly outlined. There are also tax implications associated with operating as part of an MLM company, so be clear on how your involvement may affect your personal taxes.
- Review contract paperwork. Finally, carefully review the sign-up contract (and consider having a financial advisor or attorney review it for you) so you know exactly what you’re agreeing to. The contract should outline all policies in regards to sales minimums, commission structures, how to terminate your contract, marketing rules, and more. If you have questions, ask your attorney or reach out to the company for clarification.