The Good, Bad and Ugly of Multi-Level Network Marketing

A lot has been written attacking and defending what is known as “MLM,” or multi-level marketing, sometimes derisively called “pyramid schemes.” However, prior to 2013, many journalists, investors and analysts really didn’t understand the business in detail enough to be able to comment on it fairly.

And it’s fair to say that many of them still lack basic knowledge surrounding this sometimes opaque subject.

All businesses must produce income to survive. This is done primarily with internal sales and marketing departments. Since the 1920s, many firms have tried to use direct selling (i.e., direct to consumers) using a sales force that varied in efficiency from year to year.

Products such as autos, furniture, musical instruments and even cosmetics have been sold directly. Included in the cost of selling for many of these firms was the expense of replacing at least some of their sales force annually, based on their effectiveness (or lack thereof). The percentage of this replacement varied by firm.

In the middle of the 20th century, the MLM method started to take root. MLM took the cost of recruiting and training replacement salespeople and made it a responsibility of the sales department itself. This new autonomy granted sales departments authority to grow their sales forces almost infinitely.

What had been an expense previously could now be turned into a profit center, if each salesperson could effectively recruit and train their own subordinate salespeople, creating multiple tiers of a new sales force. This in turn could generate new profits for the parent company.

The MLM Origins

In the 1980s, companies employing MLM produced better returns than traditional brand companies employing a single tier of direct selling; both types of companies faced the same economy and social changes, but the ones featuring multiple tiers of their sales forces fared better.

The explanation for this lies in that in MLM, salespeople buy products to meet volume targets through “business opportunity” incentives. This is whereby they can earn rewards by getting their own recruits take on enough of the product themselves. This is in addition to their own buying of products for demonstration purposes.

Therefore, two separate revenue streams for the parent company are created from the use of recruits — one from internally used products and the second from products that ultimately wind up in the hands of consumers (when the subordinate tier of salespeople sell them).

This latter case is also known as consumer demand. In either case, the profit margin for the parent company is the same; this holds true even if consumer demand is actually weak and most sales derive from the company’s own sales force.

Legit Network Marketing Companies or Fraudulent Pyramid Schemes?

Most MLM companies labeled “pyramid schemes” — either from an unwillingness to defend themselves from the label or from ambitious prosecutions — have traditionally failed to make this distinction, and the balance of product sold to their own salespeople has been lopsided. It is this disconnection from reported consumer demand that gets companies into trouble.

The BurnLounge court said that “rewards BurnLounge paid for package sales were not tied to the consumer demand for the merchandise in the packages.” In similar phrasing, the district court said that “such sales were not driven by market forces.”

Therefore, direct sales companies that wish to wear the cloak of legitimacy must separate the two product audiences and establish and verify consumer demand independently of their sales forces.

Another aspect to consider is that in traditional direct sales organizations, the selection of new sales recruits was done thoughtfully and carefully, due to the real costs incurred. Success could be measured when sales to consumers happened.

In most MLM companies, however, even unproductive salespeople can still result in income for the parent company, despite a total lack of selection in their sales force.

In fact, in most MLM companies, imposing selection in the sales recruitment process can inhibit sales because without selection gains are seen as inevitable; no matter how many salespeople don’t sell, if you bring aboard enough people, someone will sell something somewhere.

In these salespeople-heavy organizations, internal sales numbers can actually start to become significant. When the profit is the same for both end uses, there’s no incentive for the parent company to sell outside itself, profit-wise. Unsurprisingly, many MLM companies report a great number of new salespeople becoming inactive and reporting no significant sales to consumers, inevitably halting purchases of products for themselves. This in turn can make sales force turnover and attraction of new recruits a top priority for an organization. And this is generally where the MLM model turns into a pyramid scheme.

The MLM model ends up turning the selling role upside-down. Traditional selling regards the process as difficult work, requiring particular skill sets and personalities. With MLM, however, recruitment inevitably results in sales, and this holds true regardless of the quality of the product. The message that is repeatedly hammered home is that “anyone can succeed.”

Many MLM companies prominently feature examples of salespeople with absolutely no sales experience. And even in cases where some people may have “gotten lucky,” the source of their luck or success is never explained. The bottom line becomes simply recruitment as a path to success, leading to the danger that an MLM company will resort to fraud and misrepresentation to sustain the pyramid scheme that is necessary for its prosperity.

Both legitimate investors and swindlers are equally attracted to MLM companies due to their income potential.

The two separate revenue streams combine, and the resulting gross margins can prove to be a terrible temptation, as was seen when companies Nu Skin and Herbalife both reported margins above 80 percent, while name brand Procter & Gamble, with essentially only one revenue stream, reported closer to 50 percent. Avon, a company that sells directly but never followed through with an MLM approach it toyed with in the 1990s, regularly reports in the range of 60 percent margins. Because recruits are both buyers and sellers of the products, product prices need to facilitate the recruitment process. The marketing message communicates the product’s price appropriateness.

The buyer’s tendency to be price-sensitive turns into a seller’s tendency to justify a lower price; the success of the seller is based not just on his or her ability to sell to the consumer, but also on his or her ability to sell the opportunity of salesmanship to others via this more attractive price point. The combined gross margins tend to attract inordinate attention, including that of regulators.

In finding the firm to be a pyramid scheme rather than a mere MLM-based company, the BurnLounge court noted a lack of consumer demand. This led regulators to re-examine the process of direct sales to consumers.

Until there is a focus on non-selective recruitment, lack of product sales outside a company’s sales force, ambivalence about the sources of product profit and sales success examples unrelated to hard work, this industry is destined to have more examples of malfeasance such as this one.

Regulators need to look at margin employed to compensate for the recruitment process and its associated purchases in conjunction with the churning of recruits as red flags. In these cases, the viability and economic purpose of such a company both need to be examined closely. Fraud cannot be assumed from the company’s stock price, nor can investors (neither long nor short) be held responsible for investigating the legality of a company’s MLM efforts.

Shareholder benefits should be realized “so long as it (the company) stays within the rules of the game, which is to say, engages in open and free competition without deception or fraud,” according to noted economist Milton Friedman. But the time is ripe for regulators to make clear new rules for the MLM industry.