Two forms of investment with clearly different structures and functionalities
Written byIFC team
Updated February 1, 2023
Investors need to know where they are putting their money, especially Ponzi vs. Ponzi schemes. Although the systems are somewhat similar in their operation, there are clear differences in their structure.
Furthermore, a Ponzi scheme is an absolute case ofFraud, Ponzi scheme investors can legitimately earn a return on their investment. The easiest way to see the differences between Ponzi schemes and pyramid schemes is to examine the definition, nature, and operation of each.
- Pyramid schemes and pyramid schemes are often confused with each other; however, each has a distinctly different structure and function.
- Ponzi schemes are outright scams, while Ponzi schemes may or may not be part of a legitimate business opportunity.
- The biggest similarity between Ponzi schemes and pyramid schemes is that they both require a constant influx of new investors to sustain them; Once the influx of new investors dwindles, the program collapses.
Ponzi schemes are named after the creator of this particular scam, Charles Ponzi, who scammed a large number of investors by promising them a 50% or more return on their post-coupon investments. However, instead of actually investing, Ponzi simply pocketed investors' money. He was able to continue the scam by attracting new investors and using some of his money to pay returns to previous investors.
In return, early investors would help Ponzi attract new investors by bragging about the incredible returns they received from him. Ultimately, however, Ponzi got to the point where he failed to attract enough new investors to pay off the growing number of previous investors. That's when the scam was discovered and it fell apart.
Step by Step Process: Ponzi Scheme
- The scammer lures an investor by promising exceptional returns on investment. As an example, suppose the perpetrator of the Ponzi scheme tricks a first-time investor into giving him $1 million to invest that promises a return of 25% or more.
- The scammer never invests the money received and only takes it for himself.
- They attract a second investor who also invests $1 million. With this money, the scammer raises $750,000 and uses $250,000 to pay the previous investor their 25% "return." Keep in mind that the investor's million dollars was never invested in anything, but he believes it was and will continue to yield great returns.
- The scam can continue until the scammer is unable to bring in enough new money to pay the "returns" to all previous investors. Suppose the operator of the Ponzi scheme has managed to attract 100 investors, each investing around $1 million, and attracts about ten new investors each month.
The problem here is that even all the money invested by new investors for the month is not enough to pay 25% of the "return" to the previous 100 investors. Then the system collapses and the fraud is discovered.
Ponzi scheme operators often increase their income by charging investors significant fees for (non-existent) management of investor funds.
Ponzi Scheme Example – Bernie Madoff
Probably the most famous (or notorious) pyramid scheme was the one operated byBernie Madoff. Madoff managed to keep a Ponzi scheme stealing billions of dollars from investors for nearly two decades. By the time his scam was discovered, much of the money had already been spent and lost. So Madoff's jail time was no consolation to his betrayed investors.
A pyramid scheme is oneMulti-Level MarketingBusiness model in which members pay a fee to invest in the company, and in return receive promised payments to encourage others to invest and join the company. The scheme gets its name from the structure of the deal: a larger number of investors below, all paying money that is divided among a smaller number of investors above them.
A Ponzi scheme is typically a company that offers products for sale. However, investors are rarely able to earn a satisfactory return by selling the company's products. In order to make money, they need to recruit a certain number of new investors among themselves. Not only that, but each person they recruit must also recruit a certain number of people, each paying an application fee or membership fee and a monthly fee to maintain their membership.
Company founders easily make a profit as they receive all or part of the money received from each new investor. They make the business look attractive by showing new recruits how much money they will earn once they are recruited.
For example, suppose there are six people, and each of those six people recruits six more people, who in turn recruit six more people, and so on. So, new business prospects see a picture of eventually thousands of other people below them, each contributing money on a monthly basis, a portion of which goes to each individual directly above them in the pyramid model.
The problem is that successfully building a large "pyramid" of people under you is next to impossible in most cases. You could also recruit six people. However, the chances of each of these six people copying his feat are very slim. Most people simply drop out of the pyramid scheme after failing to recruit the required number of new people. The promised massive downline of hundreds or thousands of people below you contributing to your monthly income never materializes.
In short, while it is theoretically possible for investors in a pyramid scheme to make a profit, in reality this rarely happens. The only people with a guaranteed return are the ones at the top, the founders of the company, who make money from anyone who comes into the company and invests in it at any time and at any level. Most people, after shelling out the initial fee to join and paying the required monthly fee for several months, see that the pyramid scheme is impractical and give up without ever getting back their initial investment.
Since it is theoretically possible to make money from a pyramid scheme, it is often difficult to identify the company running it as an outright scam. The differentiator is usually the fact that money can only be made by mass recruiting new members and not by selling the company's products.
It can be seen that a key difference between Ponzi schemes and pyramid schemes is that while the participants in a Ponzi scheme generally do not take an active part in attracting new investors, while both try to attract new investors, while Participants in a pyramid scheme must be actively involved in attracting new investors to be successful.
Pyramid Scheme Example – BurnLounge
BurnLounge was a multi-level marketing company that operated like a pyramid scheme, giving investors the rights to sell music through the company's network. EITHERUS-Bundeshandelskommission (FTC)it eventually identified the company as operating a fraudulent pyramid scheme rather than a legitimate business opportunity and shut it down. Nearly $2 million was returned to investors as part of the deal.
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