The Daily Record, November 2014

With the appeal of starting your own business with little training and money, working from home, and being able to manage the business on a part-time basis, more and more people are becoming involved with multilevel marketing (“MLM”), or direct selling. According to the Direct Selling Association, MLM’s had approximately $33.7 billion in annual sales for 2013, with about 16.8 million people involved in the direct selling. These figures are up from 2012 by 3.3% and 5.7% respectively. So the question is, if MLM’s are making this much money each year, are they legitimate business opportunities or are they pyramid schemes? How do we properly evaluate these prospects to determine whether being involved is a sound business decision? 

What is multilevel marketing?

Investopedia defines multilevel marketing as “a strategy that some direct sales companies use to encourage their existing distributors to recruit new distributors by paying the existing distributors a percentage of their recruits’ sales. The recruits are known as a distributor’s downline. All distributors also make money through direct sales of products to customers”. Some of the more well-known MLM’s include Avon, MaryKay, Pampered Chef, and Amway.

What is a pyramid scheme?

A pyramid scheme is an investment solely based on a hierarchical setup. New recruits make up the base of the pyramid and provide the funding, or so called returns, given to the earlier investors/recruits above them. The scheme is initiated by an individual or company that starts recruiting investors with an offer of guaranteed high returns. At the beginning, the earliest investors do receive a high rate of return, but these gains are paid for by new recruits and are not a return of any real investment. If the scheme does not continue to bring in new recruits, the returns diminish and the business crumbles.

What’s the difference? 

Some would argue to say there is no difference between the MLM and a pyramid scheme. However, the Federal Trade Commission agrees that there are legitimate MLM’s out there. The difference between the two comes down to products. If the Company and its distributors are making money primarily from the sale of products to end-users and not boxes of product accumulating in a distributor’s garage, then it is probably a legitimate business. A pyramid scheme compensates those at the top of the pyramid with participation fees and recruitment fees and incentives. 

MLM’s in the news 

An article recently published by CNBC discussed the current troubles faced by Herbalife, Ltd., an MLM who sells personal care and weight management products. Questions have surfaced on whether the Company is a legitimate MLM or pyramid scheme. While most of the focus has been a battle between hedge fund managers, what is often overlooked is the actual impact on the often low income individuals who were lured into this “business opportunity”. After spending a few thousand dollars to start their business, the distributors are incentivized to recruit new members, and build their “downline”. Upon advancing to higher levels within the pyramid, distributors must continue to buy certain levels of inventory each month. At these levels, it becomes increasingly challenging to sell the product. Eventually, distributors realize how pointless is it to keep throwing money away and it is estimated that 90% quit within one year. The article noted that most distributors lose between $1,000 and $10,000 with the average distributor losing $3,000. While it’s true that starting your own business has its risks, and many small businesses fail, the difference between MLM’s and pyramid schemes is that the losses suffered by their failed distributors fuel the company’s profits because the losses are incurred by company incentives and policies that require distributors to purchase more product than they can sell. The Federal Trade Commission has since launched an investigation into Herbalife. However it’s important to note, the Company has not been accused of any crimes since these allegations surfaced back in 2012. 

How to assess the opportunity 

It can sometimes be very difficult to tell the difference between a true MLM/direct selling opportunity and a pyramid scheme. It is important to properly assess the business and ask the right questions to determine the legitimacy of the business. The Federal Trade Commission suggests keeping the following questions in mind:

• Is your income based mainly on the number of people you recruit, and the money those new recruits pay to join the company and not on the sales of the products to consumers?
• Are you required to buy a significant amount of inventory?
• Are you forced to buy other things you do not want or need just to stay in good standing with the company?
• Are people claiming rags-to-riches stories and lavish lifestyles made possible by participating in the program?
• Are the products genuine products of real value, at a reasonable price and the type of thing that consumers want to buy time and time again? 

Red Flags 

To assess the opportunity, it is also important to know the red flags, and be able to quickly determine when something does not seem right. When it comes to recognizing potential pyramid schemes, scamwatch.gov suggests being aware of the following warning signs:

• You are offered a chance to join a group, scheme, program or team where you need to recruit new members to make money.
• The scheme involves offers of goods or services of little or doubtful value that serve only to promote the scheme.
• There is a big up-front cost to pay for large quantities of goods.
• There are no goods or services being offered for sale by the scheme.
• The promoter makes claims like “this is not a pyramid scheme” or “this is totally legal”.
• Beware of products or schemes that claim to guarantee income or winnings.
• Remember that family members and friends may try to involve you in a scam without realizing that it is a scam.

Due Diligence

Spotting a pyramid scheme isn’t always easy. It is important to ask your sponsor and other distributors tough questions, and dig for the details. Do not consider it nosy or intrusive. Like any business investment requiring time and money, it’s worth performing some due diligence. Take the time to properly vet any opportunity that comes your way – it might just save you in the long run.