Is Network Marketing and Pyramid Selling the same thing? A layperson’s guide to evaluating the pros and cons of this often misunderstood business model. Author: Chris J. Snook Management 790 Business Administration Department San Diego State University Fall 2005 _______________________________ Primary Advisor: Dr. Alex DeNoble Professor of Management San Diego State University _______________________________ Secondary Advisor: Dr. Michael Cunningham Professor of Management San Diego State University
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Is Network Marketing and Pyramid Selling the same thing? A layperson’s guide to
evaluating the pros and cons of this often misunderstood business model.
Author: Chris J. Snook Management 790
Business Administration Department San Diego State University
Fall 2005
_______________________________ Primary Advisor: Dr. Alex DeNoble
Professor of Management San Diego State University
_______________________________ Secondary Advisor: Dr. Michael Cunningham
Professor of Management San Diego State University
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Abstract
The goal of this project was to explore the academic research surrounding the Network
Marketing/Direct Sale Industry as well as Pyramid Schemes, in an effort to locate a model and
key characteristics and differences between legitimate and viable NMO’s and illegitimate and
fraudulent Pyramid Schemes. Historical case law was also researched to locate some landmark
decisions that distinguished illegal and unethical direct-selling business models from ethical and
sustainable ones. The culmination of this paper sets forth a set of guidelines, based upon the
academic and legal research previously conducted, to act as a practical evaluation tool for the
everyday “layperson” who is evaluating one or multiple home-based or NMO’s for themselves.
The goal is to take the intricate and complex research models, and create a bridge to the “real
world” where most people are looking for a reliable metric to make an investment decision of
their time and money into an NMO. These recommendations should be used as a minimum
guideline for due diligence if the individual is serious about a low-cost, high-income potential
opportunity.
Key Words
o Network Marketing o Pyramid Scheme o Direct Selling o Organization development o Ethics o Home-based Entrepreneurs
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Table of Contents Abstract i Introduction/Industry background 1 The NMO Consumer’s biggest need 4 The Future of Network Marketing 6 A day in the life of an NMO consumer prospect 7 Landmark court cases and NMO/MLM law 13 Practical evaluation of an NMO opportunity 18 Conclusion 19 NMO/Pyramid Checklist 20 Appendix References
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Introduction:
Network marketing organizations, Multi-Level Marketing (MLM), or NMOs are retail-
selling (non-store) channels that use independent distributors not only to buy and resell company
products at retail, but also to recruit new distributors to grow an independent sales network over
time. Methods of compensation vary but often include commissions on personal volumes, group
(network) volume, and overrides and bonuses for recruitment that are used to motivate NMO
distributors (Coughlan and Grayson, 1998). According to W Gibb Dyer (Dyer, 2001), NMOs
were among the most successful organizations in the 1990s with NMO industry sales growing
from $30 billion annually to over $90 billion by the year 2000. Since its inception in the 1940’s
with Nutrilite (credited with being the first NMO) to its current $100+ billion dollar size the
NMO industry has faced tons of criticism and scrutiny regarding the ethics of its business
practices. This is because of their “dark side” likeness, the “Pyramid Scheme”. Pyramid
schemes are a distinct version of MLM or NMOs that operate in a manner that is financially
however, it must be optional and the challenge for NMO corporate officials and field leaders is
the fine gray line between providing encouragement and motivation to downline distributors
while at the same time maintaining a “free will” environment. Turnover rates tend to be high in
network marketing because people are untrained and unskilled at sales and business building,
and fail to make the amount of money they interpreted was possible during their initial exposure
to the opportunity. They get frustrated because network marketing wasn’t a get rich quick
proposition for them, and quit, blaming the opportunity instead of themselves. On the flipside of
this coin, is the distributor who pays a couple of hundred dollars (sometimes thousands) per
month on training and travel, building an organization of people that do the same, bringing in
adequate or sometimes substantial gross income, but whose cash outflow exceeds the cash
inflow. Several gung-ho distributors follow a “system” of success verbatim and earn strong five-
figure monthly incomes, but accumulate equally as much in debt to make it happen. This leads
to burnout, frustration, and negative emotions around the principles of the NMO and the industry
itself (Styler, 1998).
The take home message of the anecdotal research in this message for the prospective
distributor is to carefully analyze the minimum overhead of the NMO opportunity, and also any
potential “hidden fees” or necessary extras (training and development, etc.) and factor that into
your base monthly operating expenses so that you can compare the revenue ramp up necessary to
truly earn a net profit/income that fits your desired goal. In other words, treat network marketing
like any other business. It has the potential to be a low-overhead, highly leveraged business, but
Pyramids can end up being nothing more than a money pit and school of hard knocks education.
(Styler, 1998)
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The key premise behind a Pyramid scam is the promise of extremely high financial
returns with the apparent minimal effort. Jeffrey A. Babener, a leading lawyer and consultant to
NMO executives on case law and statutes that govern the NMO industry legitimacy, set forth the
following simple distinctions of a Pyramid vs. Legitimate MLM/NMO:
“Distributors in a network marketing program that are merely buying product to buy into
the deal, as opposed to an intention of really making a market for the product, are really
working a pyramid scheme, not a legitimate direct selling business” (Babener, 2003).
The most famous Pyramid king is probably Luigi Ponzi. Ponzi started his investment
scam by putting up $150 and getting ten friends to do the same. He promised the friends a 50%
return on investment (ROI) in 90 days or less. He then recruited a second set of friends, many
times larger than the first set to each invest $150 with the same promise of 50% ROI. With the
new money collected from the second set he repaid the first set of investors their principle ($150)
plus the 50% return ($75). The enthused investors naturally promoted the scheme which helped
provide the second group of investors the same result, and the scheme mushroomed from there.
The Ponzi machine was born, because he had delivered 50% returns in 90 days or less, plus now
he was paying a 10% finder’s fee to those who brought in new investors. The intrigue and
genius of the scheme was its simplicity. The problem was that although the original investors
(now recruiters) were paid handsomely off of their recruiting efforts, the last ones in found that
there was nobody left to recruit and the cash flow stopped, leaving them with a financial loss,
while Ponzi and his team had long moved on (Koehn 2001).
The David Rhodes electronic chain letter is another example of an illegal Pyramid/Ponzi
scheme. It started with a list of 10 people who were all told to send in money to the person at the
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top of the letter’s list and to forward the letter to ten bulletin boards, after placing their name on
the 10th position of the list. Those who participated were promised they would start receiving
money once their name reached the 5th position on the list. Koehn (2001) diagrammed how
many people would need to participate before a person would reach the 5th position as follows:
Copies in Generation Participant’s Position
10 --
100 10
1,000 9
10,000 8
100,000 7
1,000,000 6
10,000,000 5
Watrous (1999) notes that there are not 10,000,000 bulletin boards in existence, and that even if they substitute real people for bulletin boards that one soon runs out of people. Meanwhile David Rhodes and a handful of others received a
lot of $1 in the mail.
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The commonalities between Pyramid schemes, Ponzi schemes, and chain letters is that in
all cases people are enticed into making an investment of money and time by false promises of
returns that become increasingly unsustainable as more people are drawn into the scheme. This
is the genesis of the idea that only “the people at the top make any money”. That is true in the
case of a Pyramid-type deal, but that is a myth in a legitimate NMO/MLM opportunity. In a
legitimate NMO opportunity the financial return is sustainable because the money and
commissions are based upon real product sales as well as recruitment. The cash flows to the
company and the distributor are based upon true growth and true market acceptance of the
product and are therefore sustainable for the duration, and equal to every distributor regardless of
when they signed up. The challenge today is that unlike the original Ponzi schemes and chain
letters which obviously had no “real” product, the complex schemes of today have utilized things
products such as gold shares, jewelry, etc. to make the scheme look more legitimate (Reese
1999). Koehn (2001) indicates that “as long as the returns come primarily from recruiting new
people to make “investments” in jewels and in fees giving them the privelege to do recruiting,
the scheme remains fraudulent…schemes are unethical because it is not in the public interest to
have businesses that are recruitment-rather than product-, centered.”
Landmark Court Cases and MLM/NMO Law
In 2003, during the 108th Congress 1st session meeting on March 12, a Bill cited as the
“Anti-Pyramid Promotional Scheme Act” was presented to The House or Representatives (See
Appendix). Congress found that Pyramids, chain letters, and related promotional schemes
constituted a threat to interstate commerce and the financial well-being of the citizens of the
United States and should be considered enterprises which 1) finance returns to participants
through sums taken from newly attracted participants; 2) promise new participants large returns
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for their investments, and; 3) involve unfair and deceptive sales tactics, leading to the
victimization of unwitting individuals. Congress also recognized that the internet made
Pyramids an international and global threat and that the Ninth Circuit Court of Appeals erred in
defining a pyramid promotional scheme in Webster v. Omnitrition Int’l, Inc. (79F.3d 776; 9th
Cir. 1996). The act made it illegal as of March 2004 for anyone to promote via any means of
communication (internet, mail, etc.) in interstate and/or foreign commerce, a Pyramid
promotional scheme. It also clarified that the Attorney General of each state may bring action
against any person who is engaged in or about to engage in any act or practice that constitutes a
Pyramid promotional scheme (108th Congress 1st meeting…Appendix A)
The following list (Table 1.2) of practices are offered up as “red flags” to potential
prospect of NMO opportunities that the company may not be “product-centered”
Table 1.2 (adapted from Koehn 2001)
1) Focusing on growth through the recruitment of new distributors instead of on sales of
Non-harmful products.
2) Requiring substantial upfront fees from those people who are recruited to sell the products.
3) Pressuring recruits to purchase corporate products for their own consumption or to stockpile large
amounts of inventory.
The 1990s represented a period of landmark cases that uncovered and further clarified the
legal gray areas that can be abused by Pyramids disguising themselves as legitimate NMOs. In
order to understand what gray areas they abused it is important to note the prior court case
utilized in NMO court cases prior to the 1990s as the barometer between ethical and unethical
practices. FTC v. Koscot (1975) helped create the original (now inadequate) Koscot test which
stated: “a Pyramid scheme is an arrangement in which participants pay money in return for
which they receive (1) the right to sell the product and (2) the right to receive in return for
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recruiting other participants into the program, rewards that are unrelated to the sale of product to
ultimate users”. In FTC v. Amway, (1979) the court ruled that Amway was not operating a
Pyramid scheme because they were not charging a large sum of money upfront and noted the
following provisions and controls in their operating procedures: 1) 70% or all distributor
purchases were required to be resold prior to re-ordering (preventing inventory loading), 2) the
10 customer rule which required each distributor to make retail sales to at least ten different
customers each month, and 3) the company’s buyback policy which offered a minimum 90%
refund on all product returned to the company in salable condition (Vander Nat and Keep 2002).
This landmark case and ruling is what saved the network marketing industry from extinction and
it opened up and legitimized NMOs as an ethical and viable business model. However, it also
created loopholes that other cons and scam artists have exploited to feign legitimacy and operate
illegal Pyramids (Webster v. Omnitrition, 1996; FTC v. Equinox Int’l. Corp, 1999; FTC v.
Jewelway Int’l, Inc., 1997, FTC v. FutureNet Inc. 1998). For instance, even though Equinox
Int’l had a documented 70% rule in their operating procedures, as well as a 6-retail sales rule,
and required distributors to submit proof of these sales by turning in certificates each month that
documented any combination of personal consumption, retail sales, or sales to downline
distributors; the company’s records (during litigation) only showed collected receipts with a total
retail volume of 17% of distributor purchases. Equinox had no method of verifying sales to the
public and there was considerable testimony from former distributors that they were encouraged
to “make up” receipts in order to qualify for the 6-retail rule each month (Vander Nat and Keep
2002). In the case of FutureNet, Inc. it was shown that the upfront price of the opportunity was
close to 6 times the reasonable market value for the product, and was shown to compensate
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recruitment of distributors rather than retail sales. Vander Nat and Keep summarized it best in
2002:
“These FTC settlements reflect the following position: If an organization sells goods or
services to the public and the participants in the organization obtain monetary benefits
from (1) recruiting new members, and (2) selling the organization’s goods and services to
consumers, the organization is deemed a pyramid scheme if the participants obtain their
monetary benefits primarily from the recruitment rather than the sale of goods and
services to consumers (see order provisions and language in FTC v World Class
Network, Inc. 1997; FTC v. JewelWay International, Inc., 1997; FTC v. Equinox
International, Inc., 1999”)
The Vander Nat and Keep Formal MLM/Pyramid Model evaluates the level of retail-
based rewards in two main ways: (1) direct retail commissions received from the markup above
wholesale cost and (2) indirect retail commissions paid to sponsoring distributors for the volume
of product sold to the public by their downline of recruits. They do note that in applying their
model, however, prosecutors will still encounter issues of market timing and market conditions,
because a NMO going through rapid growth may have a large amount of new distributors who
have yet to develop retail sales, which can temporarily skew the results to the appearance of
potential Pyramid. They note that in such a case it would be prudent to analyze the company’s
existing distributors for level of retail-based growth and commissions at the non-distributor level
(Vander Nat and Keep 2002).
Since MLM/NMO companies build their growth on the sale of products as well as the
ongoing recruitment of new distributors, it is very possible for the corporation to start off and
operate ethically and legitimately, but to degenerate quickly into unethical, fraudulent,
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recruitment-centered Pyramid schemes. This is why it is important to understand who the
corporations top management is and what their business track record inside and outside of the
industry is. If they have a clean history for ethical business before, then the opportunity will
probably be a long-term viable venture. It is mandatory for the NMO CEOs and top
management to stay on top of the independent field leaders that come into the organization and
to strictly enforce its policies and procedures on distribution agents, because one rogue
distributor can destroy an otherwise ethical and healthy NMO. It is also imperative to have buy-
back provisions in place so that distributors do not get stuck with excess product, keep upfront
fees minimal for the right to distribute the product, and to make purchases of sales tools, training
materials, etc. optional not mandatory. It is common practice for ethical NMOs to frequently
terminate the distributorships of individuals who operate their sales teams with a recruitment-
centered vs. product-centered orientation. The most frequented online resource for due diligence
or current events regarding potential or obvious scams in network marketing is:
www.worldwidescam.com
The World Wide Scam Network (WWSN) is not anti-MLM/NMO, and in their position
paper they note that although they tend to focus primarily on the wrongdoings of the industry it
is merely out of their commitment to eradicating scams, scammers, from the universe. In the
paper they are asked the questions
“Is Network Marketing a viable career choice? Can you really make a decent living selling
products through an honest MLM program” (to which they responded):
“In our opinion, the answer is Yes! Here is our theory in this regard. The more honest
the company, the people behind it, and the product they are selling, the harder you are
going to have to work to make a living wage. This assumes that the product, whatever it
that regardless of the method by which a legitimate NMO answers the retail question, it is
imperative that the NMO must place their emphasis on selling product to customers outside of
the distribution network so that a balance between the expansion of the distributor network and
the customer base is maintained. (Vander Nat and Keep, 2002)
Conclusion:
As stated at the outset of this paper, it is imperative that an ongoing adjustment be made
to the evaluation tools utilized by prospects of NMO/MLM opportunities. Below is the final
deliverable for the “layperson” who intends to consume an NMO opportunity under any of the
previously mentioned six distributor classifications. This NMO due diligence checklist is a
consensus of the most recent academic research regarding NMOs and Pyramids, the formal
MLM/Pyramid Model and mathematical analysis developed by Vander Nat and Keep (2002), the
legal advice of Jeffrey Babener and Associates (who currently represent 10 of the largest NMOs
in the Direct Selling Industry and consult to numerous others over the last twenty years, and the
anecdotal research and conversations with several “Careerist” NMO industry veterans who have
been involved in both legitimate and illegitimate opportunities over the course of their careers.
Many such veterans interviewed have seen some of their hard work and fortunes evaporate
because of the corporate leader’s fraudulent practices For the reader the following criteria apply
when utilizing this checklist. If you have 0 “No”s then the company is solid, with minimal risk
of becoming a Pyramid. If you have 1-2 “No”s, then dig further and realize they are on the
fringe and may not have longevity past 3-5 years; and 3+ “No”s, means run fast in the opposite
direction! Furthermore, it is advised that you use this tool periodically after you are involved
with your chosen company, as marketing plans are often changed along the way, to stay
informed as to the legal and ethical direction of the company you are representing.
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NMO or PYRAMID DUE DILIGENCE CHECKLIST:
NMO COMPANY CHARACTERISTICS NMO PYRAMID RISK
CEO/Management Team:
Can you access Career Bios of Key management and document the findings? Are their
records clean?
YES NO
Product/Price
1) Is it fairly priced to comparable products? Is it high quality and is there a need in the
market? Is it proprietary to the company and only available through its distributors?
YES NO
2) Is the product backed by a strong customer satisfaction refund policy? YES NO
3) Would customers buy the company’s product if there was no financial opportunity
attached to it?
YES NO
Distribution Requirements
4) Can you become a distributor for the company without any major investment other
than purchasing a sales kit or demo materials at company cost? ($0-$100)
YES NO
5) Are qualifications for earning a check small (i.e. maintaining a minimum personal
order, and/or 1-10 retail customers per month)
YES NO
6) Does the compensation plan discourage inventory loading? Enforce a 70% rule prior to
repurchase of personal consumption?
YES NO
7) Does the company have a sufficient buyback policy for for distributors? YES NO
8) Are upline and personal commissions paid only on actual product sales to end-users (can
be both inside and outside of the network), and avoid paying bonuses or commissions for
the mere act of sponsoring or recruiting new distributors?
YES NO
9) Does the company have a trackable method of ordering to quantify how many retail
customers of the product are distributors and non-distributors?
YES NO
10) Are you safe from risk of a financial loss (above the cost of the product that you can
consume) by involving yourself in this opportunity?
YES NO
11) Do the company’s literature and training materials scrupulously avoid claims of
income potential or promises of income other than verifiable income levels within its
program? (i.e. Do they carefully distinguish what is possible from what is likely?)
YES NO
Training
12) Does the company have substantial (yet optional) training and development programs
for new and existing distributors that provides a road map and support system to reach the
top promotional levels of the company? (If it is a start up, is their adequate training on
product specs and sales in the pipeline for the near future?)
YES NO
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APPENDIX
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