Definition
A pyramid scheme is a fraudulent investment structure, where the return for older investors is generated through the capital contributed by new participants. In this model, profit is only possible while new recruits continually join and contribute funds, as the scheme does not typically have any legitimate business operations or revenue sources. The scheme collapses once no more new investors can be brought in, leaving those at the bottom of the pyramid with a loss.
Key Takeaways
- A Pyramid Scheme is an illegal business model that recruits members via a promise of payments or services for enrolling others into the scheme, rather than supplying investments or sale of products or services.
- In a Pyramid Scheme, an organization persuades individuals to make a payment and join. In return, the organization promises its new members a share of the money taken from every additional member that they recruit. The organization’s real income is derived directly from recruitment and not from any real investment or sale of goods.
- Pyramid Schemes are unsustainable and often collapse because they require exponential increases in participants to sustain the payment structure. This ultimately leads to a point where no new recruits can be found and the pyramid collapses under its own weight, resulting in significant losses for the majority of participants.
Importance
The finance term “Pyramid Scheme” is crucial because it refers to a fraudulent investment strategy, which is illegal in many jurisdictions, underlining the importance of ethical and lawful financial conduct.
This scheme operates by receiving capital from new investors, and the funds are used to pay returns to earlier investors, rather than from sustainable profits generated by productive activities.
Understanding the term helps individuals recognize and avoid such schemes that offer high returns with little risk, as they may result in significant financial losses.
Having awareness of such deceptive practices also aids in promoting financial literacy and ensures the protection of both individual and institutional investors.
Explanation
A pyramid scheme is primarily used as a profit-generating strategy, where early entrants earn profits based on the investments of later participants, rather than from any actual sale of goods or services. The purpose of a pyramid scheme is to get quick profits for those who are on top of the scheme at the expense of those who join in later.
The model works on enticing new investors to make payments or ‘donations’ to the scheme. The profit for the first participants comes from these new investments.
However, the scheme’s reliability depends solely on the continuous recruitment of newer members, as it lacks any solid income-generating mechanism. The pyramid collapses when the scheme can’t draw in enough new investors to pay the earlier ones.
At this point, the people at the top typically disappear with the money leaving the rest of the pyramid’s participants at a loss. As such, pyramid schemes are illegal in many countries due to their unethical and unsustainable nature.
Examples of Pyramid Scheme
Bernie Madoff Investment Scandal: Bernie Madoff may be one of the most notorious figures for running a Ponzi scheme, which can be likened to a pyramid scheme. He created his wealth management firm promising huge and consistent returns to his investors. He used the money from new investors to pay returns to the older ones, creating a continuous cycle, until he was unable to find new investors, and the scheme collapsed. He cheated his investors out of billions of dollars.
Zeek Rewards: Zeekler.com, a penny auction website, and its affiliated company, Zeek Rewards, recruited investors with the promise of sharing the company’s profits. People had to invest their money and recruit others to join in order to receive their profits. In 2012, the SEC shut down the company, calling it a $600 million pyramid scheme disguising as a legitimate opportunity to earn money.
Amway: Amway was investigated by the FTC in the 1970s for running a pyramid scheme. It sold health, beauty, and home care products. While the company has managed to argue about the legality of its business model and survived, many critics continue to view it as a type of pyramid scheme because substantial income can only be made by recruiting more salespeople rather than selling the products themselves.
FAQs about Pyramid Scheme
1. What is a Pyramid Scheme?
A Pyramid Scheme is a business model that recruits members via a promise of payments or services for enrolling others into the scheme, rather than supplying investments or sale of products.
2. Are Pyramid Schemes legal?
Most Pyramid Schemes are seen as manipulative and deceptive and are illegal in many countries. The legality largely depends on the various functionalities of the scheme specific to the operations within a particular region.
3. What is the difference between a Pyramid Scheme and a Ponzi Scheme?
Although similar in concept, Pyramid Schemes and Ponzi Schemes are different. The main difference being that Pyramid Schemes involve participants recruiting others in, while Ponzi Schemes involve a central figure recruiting investors and paying them returns with their own money or money paid by subsequent investors.
4. How can I identify a Pyramid Scheme?
Pyramid Schemes often have tell-tale signs. These include: focus on recruiting new members rather than selling products or services, promises of high returns in a short period, charging a large sum of money to join the scheme, and no clear product or service involved.
5. What happens if a Pyramid Scheme collapses?
In most cases when a Pyramid Scheme collapses, most members, except for a very small fraction at the top of the pyramid, end up losing the money they invested. This is because the scheme relies on new recruits to pay previous members.
Related Entrepreneurship Terms
- Investment Fraud
- Recruitment Driven Profits
- Ponzi Scheme
- Unsustainable Business Model
- Illegal Multi-level Marketing
Sources for More Information
- Federal Trade Commission (FTC): The FTC provides guidance on pyramid schemes alongside other types of fraud. The organization is a reliable source of information as they work to protect consumers against unfair business practices.
- U.S. Securities and Exchange Commission (SEC): The SEC provides resources on Pyramid schemes and other forms of investment fraud. The regulator’s aim is to protect investors and keep the markets fair and efficient.
- Better Business Bureau (BBB): The BBB provides resources on spotting, avoiding, and reporting pyramid schemes. As a NGO, they are dedicated to fostering honest and responsive relationships between businesses and consumers.
- Investopedia: Investopedia is a reliable source for definitions and detailed explanations of financial terms such as pyramid schemes. The website aims to empower users with high-quality, unbiased financial information.
