Multi-level marketing (MLM), also known as direct marketing or network marketing, is a method of selling products directly to consumers using independent sales representatives.

MLM companies tend to appeal to new recruits with promises of wealth and independence. While not illegal by definition, many MLMs have become infamous for their controversial business practices—and others have been revealed to be little more than illegal pyramid schemes.

What Is Multi-Level Marketing?

Multi-level marketing companies use people instead of retail outlets to sell their products to customers. This puts the responsibility for selling into the hands of independent distributor networks.

Under the MLM model, distributors are not employees of the company. Instead, they’re individual business owners who recruit their own distributor networks to help them sell products. Multi-level marketing firms rely upon this extended network of independent distributors to generate revenue.

How Multi-Level Marketing Works

To understand how MLM works, think of a pyramid. In our example, Alice is the first independent distributor hired directly by Direct Marketing Company. Alice becomes the top of the pyramid.

Alice recruits five independent distributors, who each turn around and recruit five more independent distributors, and so on. This fills out the pyramid that Direct Marketing Company relies upon to sell its products.

Alice is the sponsor, or upline, of everyone she recruits. The people she recruits (as well as all the people they recruit) become her downline.

The directions of these relationships are important to keep in mind because they impact the money everyone in the pyramid earns in most multi-level marketing schemes. All distributors pay a portion of their earnings to the company as well as to those upline of them.

“MLM distributors earn money from selling products to people they know, commissions from each person they recruit to the company and commissions from the sales and recruits generated from their own recruits, continuing down multiple levels,” says Christine Alemany, CEO of TBGA, a branding and marketing support agency. “In order to succeed, a distributor must continuously recruit as many downlines as possible to join their team.”

Typically MLMs offer a detailed compensation plan that outlines precisely how these upline and downline relationships work and how distributors get paid. These plans spell out things like recruiting and sales commissions as well as define the requirements a member must meet to be eligible for compensation, usually expressed in minimum sales targets and numbers of new recruits.

Pyramid Scheme vs. MLM

It’s understandable if the dynamic of MLM companies has you questioning if they’re little more than pyramid schemes. Both, after all, operate with the same pyramid-shaped structure.

So what makes one legitimate and the other an illegal scam? It comes down to the sales versus recruitment focus in the compensation plan.

According to the Federal Trade Commission (FTC), “if an MLM is not a pyramid scheme, it will pay you based on your sales to retail customers, without having to recruit new distributors.” Pyramid schemes, meanwhile, rely on continuous recruitment of dues-paying members to stay afloat, even if they require members to keep buying products that they may not be able to sell.

MLMs and the 70% Rule

For an MLM to be compliant (i.e., legal and not a pyramid scheme), it must adhere to the 70% rule that “at least 70% of all goods sold must be purchased by non-distributors.”

That means consumers outside the company need to be buying the majority of a company’s products—rather than downstream in the distributor network or with the distributors themselves stocking up on inventory. But it’s incredibly hard to prove if an MLM isn’t in compliance, note Alemany and Cory Rusin, a researcher who works closely with former multi-level marketing distributors after they leave direct sales.

“It’s almost impossible to track if a distributor has stashed unsold products in their garage or closet,” says Alemany. “For the most part, MLMs take their distributors at their word.”

And even if a distributor were clearing 70% of their inventory in a given month, the “financial freedom” offered by many MLMs simply cannot be achieved through direct sales alone, says Rusin.

“When you analyze the compensation plans of MLMs, the real money is made through recruitment,” she says.

When MLMs Fail

A pyramid scheme fails when its recruitment efforts fail since the model requires infinite recruitment to sustain income. MLM companies typically fail when suppliers or distributors revolt against unethical business practices, as in the recent LuLaRoe scandal, though individual distributors may struggle within a MLM without it outright collapsing for some time.

In short, vendors have sued LuLaRoe for unpaid invoices, and the company has been embroiled in a class-action suit from customers who received defective merchandise. The company recently settled a suit with the state of Washington, which had sued the company for running an illegal pyramid scheme.

Should You Join An MLM?

On the surface, multi-level marketing companies may appear to be a great way for individuals to become “captains of their own ship” as business owners, creating revenue from products they believe in.

But the truth is that 99% of people who participate in MLMs lose money, according to the Consumer Awareness Institute, as they struggle to resell products and recruit members for network marketing companies that often tiptoe the edges of illegality and hide the true costs of participation from participants.

What’s more, the tactics used by some MLMs can take a psychological—as well as financial—toll on distributors.

“Dr. Steve Hassan, a leading cult expert, has addressed how MLMs use manipulation and blame to ensure any failures to earn large sums of cash through the business model are placed on distributors for their lack of competence or hard work,” says Rusin.

Rather than turning to an MLM, Rusin, a former distributor for two different MLMs, advises you to think about why you think an MLM sounds exciting and explore other opportunities to fulfill those values.

Whether it’s money, wanting to quit your day job or work from home or seeking a sense of community, there are plenty of opportunities that offer those exact experiences without the hefty financial investment and psychological cost an MLM can have.

“Start your own business by exploring what your strengths are and how you can provide a needed service to others,” Rusin says. “There are inexpensive ways to get started and you’ll have created a much more sustainable and ethical avenue of income.”

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