Multilevel marketing (MLM) businesses sell products or services directly to retail customers using commission-based, nonsalaried representatives who are encouraged to recruit new representatives and form their own sales networks. They can have thousands of representatives and generate billions of dollars in annual revenue, although many of the people who join them make little to no money. Some may even lose money.
Although losing money or failing to generate significant income from an MLM business does not necessarily mean that the company is illegitimate, some MLM businesses are actually pyramid schemes. Understanding how MLM businesses work can help you avoid wasting time and money on an opportunity that is not a good fit—or is an outright scam.
How MLM Works
Also known as network marketing, consumer direct marketing, or chain selling, multilevel marketing is a business model that uses incentives to drive growth. Individual sales representatives, referred to as distributors, are not employees of the MLM business. They are independent agents who make money by selling the company’s products to other people. Representatives also make money by recruiting new representatives and earning a commission from their recruits’ sales. Generally, a representative makes more money as they, and the network they build, sell more products.
The word “level” in multilevel marketing refers to the layers of growth in the business. A new recruit joins an MLM company through a sponsor (i.e., the person who recruited them). The recruits brought in by a sponsor, including any new members those recruits subsequently bring in, are referred to as the sponsor’s downline, while the sponsorship chain above them is known as their upline.
During the start-up phase, a sponsor may tutor and train their recruits with the aim of further building the sponsor’s downline network. New recruits are expected to sign a contract and pay an initial fee to acquire some of the company’s products to sell. Ideally, a sales representative can build their network to the point where their downline earns significant income for them, in addition to their own sales. The actual commission structure is laid out in the MLM business’s compensation plan.
The Risks of MLM
One of the most significant risks of joining an MLM business is that a new recruit will not realize profits and may actually lose money. According to a survey of MLM participants conducted by AARP,[1] only 25 percent of respondents reported making a profit. About the same percentage said they made no money or broke even. And nearly half (47 percent) said they lost money. Over half described the company’s representation of achieving financial success as “not too accurate.” Two-thirds said that if they had known what they knew now about the MLM business they joined, they would not join again.
Perhaps an even bigger risk than joining an MLM business that fails to pan out is inadvertently joining a pyramid scheme disguised as an MLM. Whereas MLM businesses may have compensation plans that favor top-level distributors and make it difficult for new recruits to earn profits, pyramid schemes are outright scams. However, there is often a fine line between a legitimate MLM business and an illegal pyramid scheme.
Avoiding a Pyramid Scheme Disguised as an MLM Business
A common pyramid scheme red flag is the lack of a legitimate product, but a report from the Consumer Awareness Institute notes that this is not always the case.[2] While you should scrutinize the product or service the company sells, the Federal Trade Commission (FTC) cautions that the real devil may be in the details of the compensation structure.[3] If the MLM business is mostly focused on generating income through recruitment instead of actual sales, this is a key warning sign.
The following characteristics are also important warning signs:
- Extravagant or unrealistic promises about earning potential
- High-pressure sales tactics that play on emotions (e.g., telling recruits to throw caution to the wind and act now, etc.)
- The need for distributors to continue making ongoing purchases (including more product than they are able to sell) to be eligible for commissions and advancement (so-called pay-to-play)
- An obscure or disreputable company (Check to see if the company is a member of the Direct Selling Association.)
This list is not comprehensive. Pyramid schemes may take a variety of forms. The key to identifying whether an MLM opportunity is legitimate is a thorough and careful examination.
Reducing Risks Associated with MLM Businesses
No business venture is without risk. But many risks inherent to the MLM model can be mitigated by understanding certain red flags and using common sense.
According to the FTC, consumers should first consider whether MLM is right for them.[4] Sales is not for everybody. You need the right skill set and a solid plan to succeed. Having a quality product or service to sell is important as well.
Before taking part in an MLM business, identify your income goals and study the company’s history and compensation plan. Learn how income is earned, what expenses are involved, the time demands of the business, and the company’s refund policy. Current and past distributors can be a good source of information. Do not sign a contract unless you completely understand what you are getting into.
Next Steps
If you are considering an MLM opportunity, our law firm is here to assist you. Schedule time with our team to discuss how we can help you evaluate the opportunity and mitigate your risk.
[1] Marguerite DeLiema et al., AARP, AARP Study of Multilevel Marketing: Profiling Participants and Their Experiences in Direct Sales 3–4 (2018), https://www.aarp.org/content/dam/aarp/aarp_foundation/2018/pdf/AARP%20Foundation%20MLM%20Research%20Study%20Report%2010.8.18.pdf.
[2] Jon M. Taylor, Consumer Awareness Inst., The 5 Red Flags: Five Causal and Defining Characteristics of Product-Based Pyramid Schemes, or Recruiting MLM’s (2006 ed.), https://www.ftc.gov/system/files/documents/public_comments/2006/07/522418-12585.pdf.
[3] Business Guidance Concerning Multi-Level Marketing, Federal Trade Commission (Jan. 2018), https://www.ftc.gov/tips-advice/business-center/guidance/business-guidance-concerning-multi-level-marketing.
[4] Multi-Level Marketing Businesses and Pyramid Schemes, Federal Trade Commission (May 2021), https://www.consumer.ftc.gov/articles/multi-level-marketing-businesses-and-pyramid-schemes#pyramid.
