I don’t know about you, but lately my Instagram feed has been bombarded by MLM marketing material. Turns out, this 2020 pandemic has been a fertile breeding ground for them because of people’s craving for alternative income.

MLM has been a controversial topic in the past, so controversial that you’ll be hard-pressed to find an actual MLM establishment that incorporates the word “MLM” in their website. Some even straight up denying it, opting for a more euphemistic word like “direct selling” or “network marketing”.

But before this, I’ve never actually know why is it controversial. Some people do legitimately earn profit (a huge one at that!) by joining them, a lot of celebrities seemed to be in it as well, but there are also movies like “Betting on Zero” that zooms over how damaging they are to certain people.

Betting on Zero, Courtesy of Zipper Bros Film

So what’s the deal? Let’s investigate why in this essay

P.S. this essay is around 3000 words long, so if you just want the TL;DR, just scroll straight to the conclusion in the end

Before we investigate the “why”, we need to learn the “what”.

MLM and Pyramid Scheme

As I mentioned earlier, “MLM” is kind of a taboo word and a lot of euphemism has been used to explain the same concept. So to avoid the misconception caused by those, let’s define some terms first to base our discussion. There are a lot of textbook definitions of MLM in the internet. However to make them not boring and textbook-y, I’ll summarize and rephrase it for you. There are 3 definitions that are important:

Direct Selling is a business model that sell products exclusively through direct distributor, rather than through regular stores like supermarket. You make money by earning cuts from the product you sold. Theoretically, this is a good method to cut cost of a complicated supply chain.

Multilevel Marketing is a special case of direct selling that, in addition to commissions from product, you can also earn money by recruiting other distributor (typically called downline) and earn commissions from their purchase. Typically you won’t be recruited as an employee, but as an independent partner, since there’s typically no formal chain of command. This recruitment is recursive: the recruited distributor can recruit another distributor, in which their purchase will give earning to their recruiter and somebody above them (typically called upline), hence the “multilevel” name.

This in itself doesn’t sound bad. If any, this is quite clever: not only they incentivizes the sale of product, but also incentivizes the distributor to take care of their recruited team’s performance. So what’s so controversial about it? Turns out, the devil is in the detail.

Depending on how those 2 cashflows are balanced, it can be categorized further as a pyramid scheme:

[An] organization is deemed a pyramid scheme if the participants obtain their monetary benefits primarily from recruitment rather than the sale of goods and services to consumers – Peter J. Vander Nat and William W. Keep

That definition came from a paper detailing the economic model of the scheme. It says that while MLM itself is okay and may promote entrepreneurship, pyramid scheme however is a marketing fraud because it often misreperesent potential earnings and has deceptive marketing communication, and this is what makes MLM scheme so notorious, because people often correlate the two.

In other words, it says that MLM is not necessarily bad, pyramid scheme is.

So is that it? It’s controversial because it is often deceitful? Well.. not exactly. Those reasons may look like the answer we’re looking for, but they sound like nothing more than a stereotype. Sadly, the paper doesn’t really dive deep on why it is bad besides of those symptoms. It’s not very intuitive either: why does a certain balance of those 2 cashflows be a bad thing? Is there any fundamental reason to why such scheme is bad?

Buckle up my friend, for I’ve procrastinated enough time to make an analysis about this.

Let’s start by seeing it from 3 perspectives:

The Market’s Perspective

Unless you’re living in North Korea, we live in a free market world. We can produce and sell goods and services freely with a relatively minimal government direction. The practice of free market has its benefits (and criticisms, but that’s a topic for another time), one in particular is the belief that, with ideal regulation, competition breeds innovation.

Companies must continuously think about how to make their product better and/or cheaper in order to keep enticing customers to choose their brand rather than their competitor. This benefits both the company, as they get more profit, and the customers, as their demand are met with better valued solutions.

However, this market mechanism makes it hard for a pyramid scheme to sell their product.

How? Because (by definition) they get monetary benefits primarily from recruitment rather than sale, a recruiter must somehow gain a huge revenue from retailers they recruit. This revenue usually came in the form of an inventory sale to their downline. This in itself doesn’t sound bad. However, in order to support enough people above them, the logical implication is that the company must provide a product kit with high enough margin, which almost always higher than their competitor.

High margin product is bad because it forces them to do one of these two things: either they have to sell a shitty product at a normal price, or they have to sell a normal product at an inflated price. Either way, this will make the product itself uncompetitive.

Not only that this is bad, it’s also weird: a direct selling scheme should shave distribution cost, yet the product ends up more expensive.

DoTerra (MLM, alleged pyramid scheme) vs Rocky Mountains Oil (regular business), credits to u/pm_me_your_deviance

To justify the overvalued product, pyramid scheme company usually market their product as premium, revolutionary, one-of-a-kind, and/or hard to replicate. Usually, they’re complemented by the introduction of exotic-sounding ingredients like deer placenta, salmon ovary (I know it sounds disgusting..), alkaline water, and the like. However, they’re usually gimmicks.

This is where the stereotype of deceptive marketing tactics come from. In order to convince their retailer and customers that they’re out of the ordinary, they tend to throw marketing small-print (a claim that sounds miraculous but not really, usually came with a restrictive asterisks) and confidence tricks (paying experts and famous people for endorsement, earning hollow certification).

Usually they won’t straight up lie, because almost all trade law ban false advertising. They only need to suggest and inflate the distributor and customer’s expectation while maintaining plausible deniability. e.g.

• They won’t say that “Our products can cure COVID-19!”, but they’ll likely to say that “Our products contains X, an ingredient that has been proven to help fight many viruses” disguised in a post that mentions COVID-19 awareness. We don’t promise to cure! This is not a drug! But they may help!
• Maybe they will post a miraculous consumer testimony, appended with a small asterisk, telling you that testimonies are independent claim and may be different from person to person.

They’re (maybe) technically accurate! But it’s not the idea that the advertisers intend to evoke on the viewer’s mind, all the while reducing their legal liability. But remember, it’s just a stereotype. While the effect of a high margin product is a logical inevitability, they don’t necessarily advertise dubiously (though most are).

Sounds dirty right? Well this is not the worst part of a pyramid scheme.

If an ordinary company have a product with higher-than-average margin, they will eventually go bankrupt because no one would buy their product: they’ll either be expensive and/or bad (relative to their alternatives) and the market will eventually squeeze them out. However, a pyramid scheme won’t, because (by definition) their financial sustenance doesn’t come from customer’s money, but from recruitment. In other words, the company doesn’t have to sell well, they just have to focus recruiting people.

But hey, maybe this is part of the plan? Maybe this distribution inefficiency is the cost they have to take to have a business model that helps everyone achieve financial independence?

In order to answer that question, we must see this scheme from the second perspective

The Naive Salesperson’s Perspective

Arguably, the most enticing thing about a pyramid scheme is not how revolutionary their products are, but rather their income statement and the idea of be-your-own-boss.

I mean come on: you’re not joining as an employee, but an independent contractor. You’re practically starting your own business, how cool is that? Sure, the product may sound a little iffy and the marketing seems a little bit overzealous, but hey look at my upline! They do legitimately make a lot of money, so the system must be working!

And surely they won’t just blindly partner with people day and night for nothing, right? After all, on what responsibility they will justify the partnership to? Surely sales must be an important part of the business?

I hate to break it to you, but unfortunately, no.

As mentioned earlier, because of the overvalued product, it is very hard to sell it to an economically rational person (i.e. a person that wants the highest valued product for the lowest price). Sure, some friends of yours might buy the product to “support your business”, but that’s not going to drive a high amount of revenue like your upline does. Because of this, if you plan to rely on sale to sustainably earn profit, you will fail.

In some pyramid scheme that mandates you to buy recurring product stock, either because it is written in the partnership contract or to maintain some benefits (e.g. purchase discount), there’s a near certain guarantee that you won’t be able to continuously cover your cost with your revenue. You’ll eventually lose money. This is a bad enough situation that it earns its own name for its condition: garage qualified.

Okay, that’s scary, but then how does my upline earn a lot of money then?

Well it’s right there in the definition: you have to recruit.

The Enlightened Salesperson’s Perspective

People that’s astute enough to understand the nature of such scheme (whether through the recruitment presentation, following the money, or experience) will eventually realize that the way to reliably make money in a pyramid scheme is not to sell products, but to recruit people to be your downline.

And this is usually also advertised in the recruitment material, under the benefit of passive income. How awesome is it? You just have to relax while your downline do their own thing, and all of a sudden your bank account gets overflowed with money!

The company will usually justify it with an oversimplified analogy, things like “You’ll recruit N people, and that people each will recruit N people and earn from them, so everyone kinda gets their money back!” which describes a utopian world where everyone will magically get money from the scheme.

Sadly, this is not the case, as you come to the fallacy of infinite regress.

Unless you’re a bank, money doesn’t come out of thin air. Someone’s earning is somebody else’s spending and because I’ve established that sale is out of the picture, where does your revenue ultimately come from? Well, from the frontloading of your downlines. And where does your downlines’ revenue come from? Also from their downline. And what about them? Also from their downline. You see, this can’t go forever. A pyramid scheme doesn’t have an infinite amount of human. At some point, you will have a partner that doesn’t have any downline.

In my opinion, this is ultimately why a pyramid scheme is not a good (even toxic) business model: at any point in time, there will always be a downline-less partner (the newest recruit) and because of the reasons above, they must be at a loss. Worse, empirically, in many pyramid scheme, even a person a few level above them still lose money. Even worse, the bigger the pyramid gets, the more losing partner there will be.

Herbalife’s 2011 Compensation Statistics, not to be confused with profit

This is where the stereotype of deceptive income statement come from. While technically you can make money by joining this scheme, majority of member don’t. Only a fraction of people that is at the very top will have some profits.

In a sense, you’re draining money from your downline, which they either have to recover by draining money on their own, effectively perpetuating their scheme, or fail and go dry, in which case, you don’t have to do anything about it.. You already have their money anyway.

Metaphorically speaking, you’re not spreading an opportunity, you’re spreading a financial virus, in which you either survive by spreading the virus or get infected and suffer a financial loss.

Things get a lot murkier when you consider a scheme that doesn’t require you to purchase recurring inventory, as many scheme often do.

They’re essentially trading off the financial loss that each individual partner will potentially suffer with the amount of partner that is needed to sustain the scheme i.e. you don’t have to drain much money from each, but you have to drain from many more people.

This scheme is more benign, as each person doesn’t lose that much, but they’re still essentially doing the same harm. The fact that some people in the scheme must have a deficit still remains.

The Difference With Traditional Business

The common rebuttal to this possibility of a deficit is the argument that a pyramid scheme is essentially the same as any other business: isn’t everyone that begins their own business needs to run at a deficit as an initial investment? Don’t you have to work hard in order to make a profit? If they fail, would it be their fault of not managing their investment wisely?

Well, yes they are. But the problem is not whether you can profit, but whether we, as a whole partnership, can profit together.

In a traditional business, you can make a sustainable profit out of every branch or partner that you have: just stop expanding and focus on how to make a profitable sale. A pyramid scheme however, by the nature of the business model explained earlier, necessitates loss at any point in time.

Can you make a sustainable profit out of it? Yes you can. But can every partner, make a sustainable profit out of it? No they cannot. It’s a zero-sum game: for someone to gain, somebody else’s needs to lose.

Instead of business partnership, this phenomenon bears more resemblance to business competition, where competing businesses must take market share from each other, or a financial asset investor, where you take a profit that the previous owner should have gained.

Even saying that those things are similar is a bit generous, since business competition and financial asset investing has a positive effect for everyone: competition drives innovation and investing rewards business that has a good fundamentals (e.g. good credit score for bonds).

The only good effect of a pyramid scheme that I can think of is that it trains your marketing skill. Unfortunately, this benefit is not even unique to a pyramid scheme and considering the collateral damage you potentially done, might not have a net positive effect for the world either.

Conclusion

TL;DR, why is pyramid scheme bad? It boils down to these 3 points:

• It doesn’t support strong sale foundation: the product must have a high margin to reward enough people, making the product itself overvalued
• The partnership necessitates a loss: even though it is called a ‘partnership’, it is logically impossible for everyone in the scheme to profit.
• It is contagious: because the only reliable revenue stream is through expansion, the scheme will get bigger overtime, making even more people lose money.

So if you see that your friend is offering you a “network marketing business opportunity” and you’re genuinely interested because you see the lucrative income statement (or whatever benefit they’re offering), think twice! See if it’s a pyramid scheme.

Remember that somebody’s earning is somebody else’s spending: How sound is the business model? Where does that money come from? Is the other party get a fair exchange out of the trade? Does the company spend more effort partnering with people rather than selling their product to someone outside the company (non-partners)? Does the company sells a product that is significantly worse and/or pricier than other product that offers the same benefit?

It’s easy to get lost in the lust for wealth and accept the necessary “investment” and hustle, but have wisdom to control that desire and say no, not because it is not true, but because if you do, you’ll unjustifiably inflict financial harm to others.

The same principle and question also apply if you already partnered with a direct selling or network marketing company, whether you’re new or already have a reliable profit. Try to identify if your company is a pyramid scheme. Just because they’re saying that “we’re not one of them”, doesn’t mean they actually aren’t. Think independently!

This essay would also probably be attacked by some believers with some typical ad hominem-y comment like “he’s just jealous”, but please be courteous and asses my claim independently.

It’s okay if you don’t see it the first time you encounter them, they’re not supposed to be straightforward, but the important thing is have the boldness to stop, even if you still have hope for its future reward. Sure, you could earn it (or maybe you have), but at what cost? Ignorance is not a sin and blame won’t be convicted to one that unknowingly fell victim for such ill.

The same exoneration, however, cannot be said to those who knew but choose to do nothing.