Usually the term ‘Pyramid Scheme’ is used for illegal business model and it is a scam. But what is the definition of a pyramid scheme? When someone offers you a business opportunity that uses leverage of a network, such as multi level marketing (MLM), how could you tell if it is legitimate or not? In this article, I do my best to explain the difference between scams and legitimate businesses.
Consumers often confuse Pyramid Schemes and Multi Level Marketing, sometimes called Direct Selling and Network Marketing. This is a real shame as legitimate and proven business opportunities get dismissed by a simple ignorance.
Most people have heard of pyramid schemes and consider them to be something to stay away from. The confusion between Pyramid Schemes and Multi Level Marketing (MLM) often lies in the shape of the business when the business model is explained.
Both business models is explained as direct marketing business whereby the growth of the business relies on the word of mouth and recommendations by own existing customers, instead of expensive advertising.
The customers, who are often termed as distributors introduce the products to consumers directly and earn commissions when they purchase products or also become distributors. Then those distributors also do the same; sell products and some of them become distributors.
When this continues, naturally the network grows in the pyramid shape and that is why sometimes legitimate companies get confused with illegal pyramid schemes.
How To Tell If The Pyramid Shape Is A Scam
Over the years, some people have fallen victim to pyramid schemes which promised them substantial profits or return on investment. Victims may have invested a large chunk of money in the company which model was actually unsustainable and was a complete scam.
If the business opportunity requires an up front large investment to join the opportunity, be careful as this is often is used to pay the person who has introduced you to the scheme. If the initial invest has no value in itself such as a product or service you purchase which you can personally use, then that is most likely a scam.
If there is a minimum number of people you have to recruit before you can get your first commission, ring an alarm bell as again the business is designed for the people who are higher in the pyramid hierarchy to profit as this shows that the business is just about recruiting new members and not much else.
If you are not sure exactly what they are selling or if the product range they sell are of low quality or not backed up by number of sales per year, again suspect the business to be a scam. A pyramid scheme often only relies on the joining fee to run the business and completely unsustainable.
The bottom line is that the pyramid scheme is a scam because the business model is often designed for the top person to profit from it and not others who join later. Check out the video below.
What Does Legitimate Business Model Look like
There are many legitimate multi level marketing (MLM) companies in the world which have been in business for many decades. If MLM is a legitimate business, recruiting new members is an option as they often sell quality products and services to build their own business as a distributor.
The business model should also be designed in a way that members who produce sales results are rewarded adequately and fairly in comparison to a member who doesn’t sell as much no matter which position the member holds in the network.
For example, imagine a scenario; your friend, John has introduced you to the business opportunity but does not have any other member in his network. You then get your business going and work really hard and have generated substantial sales while John sat back and not sold any products or recruited new members himself, should he have part of your commission just because he joined the company before you? No, it is not fair if he does, does it?
Legitimate MLM companies have compensation structure that is designed to be fair. Members are often rewarded for their effort in growing their own network and helping others to do the same. That is how the residual income is earned alongside sales commissions.
Why People Join An MLM Company
Probably the oldest and the original MLM company is Tupperware which started in 1946 and still going strong, generating over $2.2 billion in revenue.
There are two main reasons that people decide to start their own business as a distributor of an MLM company.
1. Low Cost Start Up – unlike buying into a franchise, your initial outlay is relatively low in comparison but still have the benefit of having the support and mentorship of the parent company as well as the brand that has already been around and have a proven record.
2. Leverage – this is what is unique about the MLM which not everyone seem to understand but the distributor themselves are leaping the benefits. To explain this, I compare an MLM business and a traditional business model in a very simply.
Let’s say you have a product you sell at $20 gross profit (which is what you take home). In order to make $2000 profit, you need to sell this 100 times to one person or find 100 customers. I have created an infographic to explain below.
In order to find 100 customers, in traditional(conventional) business model, if you do it on your own it may take a long time, so traditionally you might hire a staff or two to do this which will cost you either in commission or their salary and deducted from your final gross profit. Let’s say this is at 10%, so you end up with $1800 in profit as a result.
In MLM, as part of your business is to find other distributors who will also find other distributors, and those distributors will find their own and so on. But because they are all in your network, you will receive the profit generated by those members in your network. This means you do’t personally need to find 100 customers, which is also known as a compound effect.
The infographic is for the purpose of illustrating the leverage and not necessarily represent the exact number of distributors needed to generate $2000 profit as each MLM will have their own compensation plan.
3. Residual Income – the majority of MLMs will pay an ongoing commission when your network becomes a certain size, sometimes known as bonus payment or residual commissions. This may not be dependent on the number of sales you made in one month or number of distributors recruited in one period. This is not unique to MLM and some other businesses have a model to generate residual income whereby customers pay a subscription, such as Netflix. The distributors receive a potion of this residual sale as a member in addition to off time sales commissions
These three aspects of an MLM system is attractive to people who are looking for a profitable business system, backed up with mentorship and support from the parent company and their up line distributors. Moreover, as it is a known fact that the majority of millionaires in the US have become millionaires through MLM business, so it is a proven method to transform peoples financial position.
However, not everyone who starts MLM business succeed. It is down to individuals to make it work or not and this is no different to 95% of all business start-ups failing within the first 5 years. You have to remember that it is not the business system that is wrong. Some people who sign up to MLM opportunity who are not prepared to treat it like a real business or expected it to be easy end up not making much money.