A Ponzi scheme or pyramid scheme is the term used to describe business models that require an ever-increasing number of participants to function, resembling a snowball rolling down the slope and steadily growing at the same time. Supposed profits, or rather liquidity surpluses, arise almost exclusively from the fact that new participants participate in the system, contribute or generate their own capital. Sometimes there is no product at all or only an overpriced product, so that a fraud is committed.
Each participant sometimes receives a share of all the income received by the participants he has recruited, from which the term pyramid scheme is derived. This means that not only the founders, but also participants who have been with the company for a particularly long time can benefit. Alternatively, the founders themselves deliberately move all income within their system, so that investors are led to believe that they will receive a return, while the majority of the investments are embezzled and thus lost.
Ponzi schemes are special cases of constructs that depend on constant growth under finite framework conditions and therefore usually collapse or blow up within a few years.
In most countries, they are now – at least partially – illegal. In the professional world, Ponzi scheme and Pyramid scheme are sometimes used synonymously. Despite similarities, however, there are clear differences. What both systems have in common is that the number of participants must increase exponentially in order not to collapse (but with much higher growth rates in the Ponzi scheme), and that the contributions of new participants cover the profit distributions of the existing participants. The main difference, however, is:
- In the Ponzi scheme, the founders of the scheme are known to the participants, while the source of the profit distributions is disguised.
- In the case of the Pyramid scheme, this is the other way around: new entrants rarely have contact with the founders, while the source of the profit distributions is transparent.
The collapse is inevitable because the total deposit or the number of participants would have to grow exponentially, which is not possible in the long run in a world of limited resources. If a new participant has to recruit two members, there will be four in the second stage, eight in the third stage, 16 in the fourth stage, and so on. In the tenth stage there are already over 1000, in the twentieth over a million. If a participant has to recruit five members, there are already almost 10 million in the tenth stage, and more than there are people on earth in stage 15.
In pyramid schemes, products are passed on from top to bottom, resulting in an increase in price. A advertises B, B has to buy a product from A (e.g. it costs B 50 cents more than from A), B can now resell this product, or C, who buys the product from B from now on (50 cents more expensive), etc. This only works up to a certain price, after which the system collapses for the lowest. The dangerous thing about this is the flow of products from top to bottom in width, the transfer of products from A to B to C and the change in prices.
It is often difficult to distinguish illegal pyramid schemes from legal structured distribution or multi-level marketing. The transition is fluid and partly depends not only on the design of the rules, but also on their actual implementation. The basic question for the distinction is: Would the customer purchase the product offered even if he did not receive any commission for referring new customers?
In a Ponzi scheme, the focus is regularly on the earning potential for the acquisition of new customers. This is already evident in the address: Ponzi schemes advertise with earning potential instead of consumer products. In the case of permissible multi-level marketing, the product is distributed primarily to consumers who do not become part of the distribution system at the same time, or a legitimate consumer network is established where the distributors are also the consumers. In this case, any costs for transporting goods, advertising and other operating expenses (non-wage labour costs, rent of business premises, wholesale margin, etc.) are saved and instead distributed to the sales partners as a bonus.
Indications of an illegal Ponzi scheme are:
- Earning potential consists mainly of the benefits granted for the recruitment of new members, often referred to as “passive income” (or “independent income”).
- The product sold is overpriced.
- The trading margin or sales commission is unusually high for the product and industry.
- There are hardly any customers who would purchase the product at the offered price without any commission prospects.
Image source: https://onlinebenjamins.com/what-is-a-multi-level-marketing-scheme/