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Multilevel Marketing (MLM) vs. Pyramid Scheme – Red Flags to Watch For

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Tell me if this sounds familiar: An acquaintance from high school reaches out on Facebook to let you know about a great opportunity she wants to share. A casual acquaintance from church suddenly emails to invite you to a get-together at their house. Or one of your followers on Instagram leaves a comment encouraging you to check out a new work-from-home business venture that lets you set your own schedule.

The product might be leggings from LuLaRoe, makeup from Rodan + Fields, or a weight-loss shake from Plexus. It’s suddenly everywhere in your inbox and all over your feed, with virtual “parties” and heartfelt testimonials from distributors and their customers. This is multilevel marketing (MLM) in the age of social media.

Companies like Stella & Dot, Jamberry, and Pampered Chef all fall under the category of direct sales, also called multilevel marketing or networking marketing. And they’ve exploded in popularity in the last decade. The Direct Selling Association, a national trade organization for MLMs, estimates that in 2017, 18.6 million people in the United States were involved in direct selling. That’s up from the Direct Selling Education Foundation‘s estimate of about 11 million in 2001 and a mere 6.3 million in 1994.

You won’t find MLM products on store shelves, and they don’t advertise to customers through traditional channels like TV and print ads. Instead, they encourage their distributors to market the company to friends and family through word-of-mouth. And many MLM distributors rely heavily on social media to expand their network, recruit new distributors, and make more sales.

Online selling parties and promotions have replaced lugging your wares door to door or having people over for a Tupperware sale. These days, distributors sell to social media friends and recruit new distributors from all over the country.

What Is Multilevel Marketing?

Multi Level Marketing Mlm Diagram Of Management

MLMs work something like this: The company has a team of distributors – whom they often describe by using terms like associates, consultants, or directors – who are responsible for selling their product directly to consumers. They usually drum up business by word-of-mouth and through leveraging existing relationships with family members, neighbors, and friends. This is the “direct” part of direct selling.

These companies also encourage distributors to recruit more people. Recruiters earn a small commission on every sale their direct recruit makes. If the person they recruited recruits more people, the original distributor gets a commission on those sales as well. The more people a distributor has below them – called their “downline” in MLM parlance – the more commission they make from other people’s sales. The tiers, or levels, of distributors are why they use the term “multilevel marketing” to describe this structure.


Is MLM a Pyramid Scheme?

Money Cash Pyramids Houses On Wooden Table

One of the refrains you’ll hear most often from people in multilevel marketing is that it is not a pyramid scheme because pyramid schemes are illegal. Just because someone’s running a business doesn’t mean it’s a lawful business. Money laundering, cockfighting, and insider trading are all illegal, and yet they still happen with some regularity.

However, it’s technically true that most MLM operations are structured to get around being labeled a pyramid scheme.

As a result of the 1975 case FTC v. Koscot Interplanetary, the Federal Trade Commission (FTC) stipulates that as long as a company’s product is for sale to the public instead of only its distributors, it’s a lawful business. If participants can make money both from recruiting others and from selling a product, the business is technically an MLM instead of a pyramid scheme. If they can only make money by recruiting others, it’s an unlawful pyramid scheme.


MLM or Pyramid Scheme: Red Flags to Watch For

Before you sign up to sell with an MLM, look for red flags of a scam with some pretty window dressing. There are several common ways distributors lose money on MLMs. If you see signs of any of them, take a pass.

1. Inventory Loading

When a company requires its distributors to purchase more inventory than they can realistically resell in a reasonable time frame, it’s called “inventory loading” or “front-loading.” A LuLaRoe consultant must make a minimum $5,500 initial investment in inventory, for example. But Business Insider reports it may take as much as a $15,000 investment for a distributor to be profitable.

If a company wants you to assume the risk of thousands of dollars in inventory, think carefully. Do you really have that kind of money to invest in this endeavor? Be especially careful if you’ll have to look at options to finance your new business.

Some MLMs also require distributors to purchase a set amount of monthly inventory to continue to qualify for commissions and rebates from recruits and people in their downline. That leads many distributors to buy products they don’t need because they’re still trying to offload last months’. Most MLMs don’t require their distributors to keep sales records. So they don’t know if the distributor is buying inventory because they’re running low or because they feel they have to.

If it looks like the MLM only cares about the products you’re buying from them instead of what you’re selling nonaffiliated customers, beware.

2. Training or Convention Costs

Some MLMs don’t require distributors to spend a ton of cash on inventory, but they nickel and dime them in other ways. For example, are there expensive training seminars you’re expected to attend to be successful? Is there a quarterly or annual convention you must go to on your own dime? What happens if you don’t do any of the extra training or distributor seminars? Will you be ineligible for updates, information, or new product releases?

Often, the training – or recruitment or product purchases, for that matter – is tied to whether or not you qualify for rewards and benefits the company offers. Very few distributors qualify for these thanks to all the hoops they have to jump through. The FTC warns this is a frequent red flag a business is a pyramid scheme.

Even if it’s a legitimate MLM, make sure you can afford the training and cost of traveling to events without relying on your distributor income. You might not make that much at first – if ever.

3. Website Fees or Monthly Service Fees

With the advent of social media and the prevalence of digital marketing, many MLMs now encourage their distributors to rely heavily on selling through Facebook, Instagram, and personal distributor websites. Many MLMs even set their distributors up with website templates and prewritten social media posts to share – for a price, of course.

There are often monthly service fees for these kinds of tools, in addition to your startup fees. So include those when you price out your costs.

Finally, are there any other monthly costs you must pay to stay with the company? If so, proceed with caution.

4. Wholesale Price vs. Retail Price

Compare the products’ wholesale prices to their retail prices. That’s your profit margin. With slim profit margins, you won’t make much money on customer sales alone, especially if you have to pay sales tax and shipping on wholesale orders.

In these situations, the profit comes when you cultivate a big downline. If the potential earnings come primarily from recruiting rather than sales, that’s a telltale sign a company is verging on a pyramid scheme.

5. No (or Very Limited) Return Policy for Unsold Products

What if you buy $14,000 worth of product and then decide to get out of the MLM game before you’ve sold them all? What’s the company’s policy on buying back unsold inventory? Get the return policy in writing and scrutinize it before you sign up. Make sure you understand the restrictions and penalties. Examples of common policies include time limits for returns, exclusions of seasonal or limited-edition products, partial refunds for the price paid, and prolonged refund processing.

A reputable company stands behind their products and will take back any unopened, undamaged inventory within a reasonable amount of time. Scam MLMs make their money selling expensive junk inventory to unsuspecting associates, who then get stuck with a garage full of worthless items like snowman-print leggings.

6. No Earnings Statements or Distributor Income Information

Is your Instagram friend vague about how much money they’ve made from this “amazing opportunity”? Does the company highlight the stratospheric wealth of its top distributors without detailing how much income the average associate pulls in?

Before you sign up, ask about seeing an income disclosure statement or distributor income information from the company. How much can the average part-time associate – someone who works less than 20 hours per week – expect to make in a month? If the company doesn’t have that information or won’t release it to you, run, don’t walk, in the other direction.

Pyramid schemes masquerading as MLMs are infamously tight-lipped about how much money their distributors earn from sales. That’s partly because most of the profit in this structure comes from recruitment, not sales, which Cornell Law School says isn’t a sustainable model.

7. Attrition Rate

Jon M. Taylor, founder of the Consumer Awareness Institute, conducted a comprehensive study on multilevel marketing in 2011. He found that after five years, more than 90% of distributors stopped working for their MLM. After 10 years, an alarming 95% of distributors had left the company.

Going into business for yourself is always risky. But comparing MLM attrition to other small-business attrition, Taylor found that only about 64% of traditional small businesses have folded within five years. Look for an MLM that shares its attrition rates across all distributors, not just the highest performers. If they don’t, it’s probably because they have something to hide. Find out before you sign up, not after you’re already emotionally and financially invested in the company.

8. Market Saturation

In addition to getting a comprehensive view of distributors and their success with the MLM, make sure you understand the buyers you’re hoping to target. What is the market saturation for this product in your geographic area and extended social network? Distributors who are among the first have better luck making sales and recruiting a downline.

LuLaRoe, for example, has over 80,000 consultants, up from only 30,000 in 2016. With that many people across the country selling leggings and cotton dresses, is there still a demand, or has everyone you know already been solicited?

9. Time Commitment

Many distributors find they have to devote more hours than they originally planned to make money with an MLM. It’s often more of a full-time job than the easy side hustle they thought they signed up for. A 2017 study, also by the Consumer Awareness Institute, analyzed 15 years’ worth of compensation data from 350 MLMs in the U.S. and found that 99% of distributors actually lost money.

The highly touted successful distributors are usually those who can devote an enormous amount of time and energy to both selling and recruiting to build their downline.

If you’re looking for an interesting part-time job, some MLMs don’t require you to purchase inventory or rely on recruiting to make money. Evaluate the amount of time you can devote to this business, and make sure it’s compatible with what most of the profitable distributors are doing.


How to Be a Successful MLM Distributor

Woman Concentrating Planning Business Strategy Office

If you do join an MLM, there are a few key ways to help set yourself up for success.

1. Stay Organized

Keep meticulous records of your initial investment, how much money you make, and how much time you spend on both sales and recruiting. In addition to helping you determine your hourly wage and success rate, this information will be important when it comes time to file your income taxes.

2. Be Realistic

Make sure your goals for success with direct sales are realistic. If you want a part-time job with flexible hours, an MLM might not be the best fit. But if you want something that lets you tap into your network, meet new people, use your social media savvy, and give you experience with direct sales, a reputable MLM might be the part-time gig you’re looking for.

3. Know When to Call It Quits

Don’t overcommit to an MLM or continue investing in inventory and training if it doesn’t seem to be working out. Humans are incredibly risk-averse creatures. It can be hard to admit you made a mistake and need to cut your losses. But don’t compound the issue by throwing good money after bad.

It’s far less painful and financially damaging to lose $500 in a failed business venture than to lose $5,000 because you didn’t walk away when you should have.


Final Word

Even if a company is technically following the letter of the law, that doesn’t mean it’s a good idea to get involved with it. After all, payday lenders are lawful businesses. But no one is going to argue a payday loan is the best bet when you’re looking to borrow money.

After you’ve researched an MLM carefully, you might decide you’re better off doing something else. But if you’re going to join an MLM, keep in mind the oft-used warning “buyer beware.”

Have you ever sold for an MLM? How did it work out for you?

Marisa Bell-Metereau
A grant writer and personal finance fanatic, Marisa is an avid traveler who lives in Pittsburgh, PA. When she’s not reading or writing for work or play, she enjoys running, thrifting, and searching for the most authentic Mexican food in the city.

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