The Explosion Of Risk In MLM

The following is a guest post from Dave Vaughan.  Let him know your thoughts on this post in the comments below.

Here is my analysis of the predatory practices of Direct Selling companies. We should take much more care in regulating this industry as it functions very different from all other businesses. It turns customers into sellers and commits them to purchasing contracts on a quarterly or monthly basis. This creates the pyramid structure that massively reorganizes wealth.

Business is often characterized most simply as the careful management of risks. Every first year business course introduces students to the principles of SWOT analysis before launching into a series of case studies that examine the odds of success for large and small businesses alike. These cases are applied to nearly every industry. I myself recall being fascinated by the graphical demonstrations Ms. Laura Allan offered us in the 8:30AM lectures at Wilfrid Laurier University.

Never did I think this would be challenged thousands of miles away and more than a decade later when I lost a close personal relationship to someone because of their association with a multi-level marketing company. As with most personal crises I face, I was initially convinced the blame lay entirely with me. After consultation with mutual friends however I realized I was not the only victim of this loss, and I uncovered a deep system of control and manipulation that not only my friend was exposed to, but nearly everyone within the network of these multi-level marketing businesses.

You see, they do not work like a traditional business. A normal business will develop a product from an idea and market the product to customers that see the product matches a need they have. I buy Nike shoes not always because my current pair are in shreds, but because I have developed a brand loyalty to Nike and I have found a pair that match my tastes. I go to a restaurant for a meal when I’m hungry, it’s not the most affordable restaurant always, but at the time I make a decision based on past experiences, proximity and personal conditions.

The risks of developing a product are mitigated and solved by standard business decisions (product expansions, IPOs, reorganizing board structures, etc…). When it comes to network marketing however, the spread of risk is very different. Let’s have a close look at a graphical representation.

MLM Cycle 1

We look at this one person who chooses to enter a company on the basis of balancing their risk. The perceived risk and the actual risk (as a very forgiving estimate) are equivalent. On this basis, risk loving and risk neutral agents are most likely to enter the market as the perceived risk level is equal to the expected return of the business. 

Her potential for reward is 5 units (you can think of this as money, knowledge and personal achievement) and her potential loss is also 5 (includes money, destruction of established social networks, precious time and general concept of reality). 

This expansion happens in the second cycle to the downline members that this initial agent recruits 2 new members who face the same risk decision as they did:

MLM Cycle 2

It is worth noting that for the first individual, their risk level has not lowered. They are still not making any profit, but the addition of two downline members has meant the degree to which they risk losing additional units is lowered on the basis they now have agents to help mitigate that initial risk. It should be noted however the total risk has expanded. The initial risk was 5 units in cycle 1, but in cycle 2 it is now 14 units. This contrasts against the potential opportunity however, which expands from 5 units to 16 units in period two. Overall, at this early stage it can be argued that this business serves a potential net benefit to them. 

These individuals face the same risk decisions as in common throughout these companies. There is the common thread of claims to duplicate the success of past champions within network marketing. There is a continued insistence that if these methods are followed, success will only be a few years away. 

It’s in cycle 3 where hope starts to blossom as the first agent receives their first taste of real profit.

MLM Cycle 3

With the addition of two new downline distributors for each of agent 1’s distributors, agent 1 gains credit for their purchases. These additional purchases increases the volume (BV) benefits received by agent 1, which substantially increases their profit into an area where they are making money.

They have increased requirements though as they have expanded their business and begun earning a noticeable degree of cash. This increases their risk, but at the same time, it has lowered their risk to social vulnerabilities as the primary responsibilities of recruitment, and thus time and within network social tension is reduced.

Once again, the newest distributors face the same decision that the agents who recruited them did in deciding to enter the market. The agents recruited by agent 1 also encounter the same situation as agent 1 did in period 2 where their risk level has been reduced by 1 unit in result of recruiting two downline distributors.

The overall real risk rating in this cycle is now 32, and benefit is 2, yet the potential for benefit remains high at 36 units. This really begins to sour however in the fourth cycle as the expansion of new risk outweighs the benefits received from their introduction to the business.

MLM Cycle 4

It should be noted immediately that these entrants now face a new unit of risk as a result of the expansion of this business scheme in the local economy. There is an increasingly limited number of people interested in joining these companies, so on this basis of local economy market saturation, their perceived risk level is expanding. This is also a result of the time for them to find new recruits and enter cycle five will expand as limited agents remain interested in the ‘opportunity’ offered by this business. This does not need to be symmetric, the perceived risk may differ across new agents, however for simplicity sake it is assumed more risk-loving (or risk unaware) agents now enter the market while risk neutral agents tend to avoid this opportunity at this time.

Agent 1 now reaches the highest volume requirement thresholds and with these requirements they now face a very high risk of the network collapsing, as they have a great deal of money invested in the sustained value of the goods in this fabricated demand economy. Many often assume it’s those at the bottom of pyramid schemes who lose the most, but the churning low risk nature of the business does not mean they lose a lot unless they invest unwisely in stock overages, which can happen independently or upon the request of their upline. Agent 1 has begun to make a decent income at this stage however, and has inspired those in the lower levels of the business to maintain hope in their eventual success if they find more interested distributors to participate in the business.

In order to be consistent with duplication standards suggesting within this network, levels 2 and 3 of this organization face the same realities that those the level above them faced the previous period.

The real concern arises in cycle four when one examines the resulting economic risks. The potential benefit is a sizable 65 units. There is also a commendable 8 units of profit that did not exist prior to entry into this business. Most alarmingly however, the risk level has now expanded to 87 units. This is the first time it has exceeded the measured potential benefit of the business opportunity. In the next cycle this number will be further amplified to 164 units of risk relative to 24 units of real benefit and 143 units of overall benefit (includes equal valuation of profit and possible benefit).

This gap between added risk and benefit will continue to widen and the expanding risk of local market saturation will begin to affect levels much more quickly. It is for this reason alone that these business schemes must be corrected as there is no other business that operates in this way. Insurance markets pool risk to lower overall costs of those in the insurance market. Real estate agents operate under a larger organization that helps to house the large costs associated with leveraging properties. MLMs take a minimal level of risk and multiply it across an exponentially expanding network to create an overall negative distortion in the economy at large.

Companies must be held accountable for this largely overlooked issue. Please do your part in making sure they are more aware of this issue that they often are too ignorant to resolve.

(It is my opinion, these companies do understand this and take advantage of their representatives knowingly. – Ethan Vanderbuilt)