What's a "Ponzi Scheme?"
Volume 13, Number 20
Issue 620
The Securities and Exchange Commission's (SEC) website (www.sec.gov), describes a "Ponzi Scheme" as "a type of illegal pyramid scheme named for Charles Ponzi, who duped thousands of New England residents into investing in a postage stamp speculation scheme back in the 1920s. Ponzi thought he could take advantage of differences between U.S. and foreign currencies used to buy and sell international mail coupons. Ponzi told investors that he could provide a 40% return in just 90 days compared with 5% for bank savings accounts. Ponzi was deluged with funds from investors, taking in $1 million during one three-hour period-and this was 1921! Though a few early investors were paid off to make the scheme look legitimate, an investigation found that Ponzi had only purchased about $30 worth of the international mail coupons."
So what's a pyramid scheme? The SEC's website defines a pyramid scheme as an enterprise that attempts to make money by recruiting new participants into some sort of program/sales opportunity. According to the SCC, "the hallmark of these schemes is the promise of sky-high returns in a short period of time for doing nothing other than handing over your money and getting others to do the same. The fraudsters behind a pyramid scheme may go to great lengths to make the program look like a legitimate multi-level marketing program. But despite their claims to have legitimate products or services to sell, these fraudsters simply use money coming in from new recruits to pay off early stage investors. But eventually the pyramid will collapse. At some point the schemes get too big, the promoter cannot raise enough money from new investors to pay earlier investors, and many people lose their money."
Over the years that I have been a CPA, I've seen many people be enticed into becoming part of a sales network that involves direct selling of products to friends and relatives. I've written about this before and I've named the names of companies that entice you to become part of a network. Though these companies purport to have legitimate and special entrepreneurial sales opportunities, I've always thought nothing is further than the truth because they resemble glorified-but businesslike-pyramid schemes.
From the Federal Trade Commission's website, "Some distributors sell more than diet and exercise plans, vitamin supplements or wonder creams. Many may sell 'opportunities,' too, a chance for you not only to buy, but also to market, the products. In addition to describing the benefits of their product or program, these distributors may encourage you to become a distributor. If you sign up as a distributor, you may be promised commissions or other rewards for both your sales of the plan's goods or services and those of other people you recruit to become distributors. These plans, often called 'multilevel marketing plans,' sometimes promise commissions or rewards that never materialize. What's worse, consumers are often urged to spend or 'invest' money in order to make it."
If a company attempts to recruit people to "work at home" or "network your friends and relatives selling ______" after allowing you to purchase a "kit" for a few hundred dollars, I've always thought that this is nothing more than a pyramid scheme similar to what the SCC and FTC describe. In fact, the "levels" of participation in these multilevel marketing ventures are similar to the levels of participation of "moving up" shown in illustration at the SEC's website. I interpret these levels to be the traditional geometric proportions of pyramid schemes.
If 6 people start an "entrepreneurial" idea at Level 1, it will take 36 people at Level 2 to sustain returning the first level's investment. It will then take 216 at a Level 3 to sustain and/or repay Level 2. Level 4 will need 1,296 people to pay back Level 3 and Level 5 will need 7,776 to "cash out" level 4. Level 6 will need 46,656 entrepreneurs to return Level 5's investment. Level 7 will need 279,936 to find enough market penetration to make enough money to pay back Level 6. Level 8 will need 1,679,616 people get into the business to be able to return Level 7's investment. Level 9 will need 10,077,696 and Level 10 will need 60,466,176. The next level-Level 11-Will need 362,797,056 people selling a product or generating money in order to pay back Level 10. This is more than the population of the United States.
I see many multilevel marketing ideas each year that attempt to sell products or services readily available anywhere. If you decide to join an organization involving a linear sales force with "uplinks" and "downlinks," you will become part of the traditional "Level" of the pyramid scheme. The problem is that people involved in the selling of products that are easily available at malls, Target T, WalMartT and through traditional (and better) service providers, sooner or later run out of friends to sell their product to and find it nearly impossible to "crack" any third-party (strangers) market. At that point, the solution is usually to recruit people to become new Levels and those new people will be even less successful because-by then-most people have already heard (and passed on buying) the alleged product.
David B. Robinson, CPA
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