How Valid Are Bill Ackman’s Claims that Herbalife Is a Pyramid Scheme?

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In late 2012, hedge fund manager Bill Ackman announced a large short position in Herbalife (NYSE: HLF  ) . The investment was driven by Ackman's belief the multi-level marketing company was operating as a well refined, illegal pyramid scheme. Last week, the Federal Trade Commission announced it had begun an official inquiry into Herbalife. While an investigation does not imply any wrongdoing, the probe does raise an interesting question on whether some multi-level marketing companies are actually glorified pyramid schemes. 

Differences between MLM and pyramid scheme
In multi-level marketing companies, sales people are paid not solely based on what they sell, but on the sales of employees they have recruited into the company. Therefore, the advantage in compensation is always highest for the members of the company who joined earlier. This level of success can be misleading to new salespeople, because the higher the number of tiers above new employees the lower earning potential they will have.

The most common sign in discovering a pyramid scheme is whether a company makes more sales to people within its selling network than to outside retail consumers. A common method in these schemes is selling training material, classes, or products to salespeople under the impression they will lead to impressive returns on investment. However, many times selling the company's products does not generate enough profit to break even for the new recruits. Often, the only option available to generate income is by continuously recruiting other members. The recruiter will receive bonuses for the recruitment, the purchase of training material or classes, and any additional sales of the recruit. A company operating under a pyramid scheme usually fails once recruitment slows down. 

False promises and false hope
A consistency among most multi-level marketing companies is new recruits are promised the potential to earn high salaries selling products. The promises are often followed by examples of people earning exorbitant salaries from the system. However, these people may have entered into the company at a different level or operate as outliers. For example, the Direct Selling Association states the median salary of MLM salespeople at $2,400 per year. That number is even less impressive when using the example of Herbalife -- 88% of its distributors did not earn a single dollar of commission in 2012. However, 0.7% of the sales force makes six-figure salaries and 0.2% makes an average over $700,000. This disparity creates a business structure that critics claim easily fits into a pyramid form.

Bill Ackman's argument
Bill Ackman focuses on this gap in earnings as a key sign Herbalife is a pyramid scheme. He claims the multiple tiers of salespeople are intentional to force employees to focus on increasing sales through recruiting. Ackman's other claim is that Herbalife explicitly defies the rule on selling more to outside consumers than to internal distributors. Through several interesting accounting and pricing assumptions he calculates organic retail profits to be $144 million instead of the $2.5 billion Herbalife claims. This is compared to earning $1.1 billion in payouts from its distributors. If these numbers are correct, there would be a clear case for declaring Herbalife a pyramid scheme.

The company's supporters claim Ackman's comments are erroneous and often misleading. The company credits a large amount of the earnings gap to those members who either work part-time or only became distributors to receive discounts on products. They do not deny many recruits earn minimal salaries, but state nearly 80% of distributors have higher sales than their sponsors.

While there is clear evidence and examples of the failure of many new recruits, this does not confirm a pyramid scheme. The business has flaws, but if it is earning more than half of its sales from outside consumers, it fits the guidelines currently in place. In response to these guidelines, Herbalife reports a strong performing retail operation, which brings in well over 50% of its profits.

Questionable business models are not illegal
Bill Ackman claimed he would continue fighting even if the FTC found Herbalife had done no wrong, because he had a civil right to protect the people. While this may seem drastic, it does bring up the question of whether the FTC's current description of a pyramid scheme is too lenient or vague. Critics claim just because a company generates less than half of sales from inside its network should not disqualify it from being a pyramid scheme. Meanwhile, supporters of multi-level marketing say it is an effective and fair business model that has proven successful for many.

In regards to Herbalife, we are no closer to a final decision on whether it is in fact a pyramid scheme. However, the results of the FTC's investigation may create a precedent for all MLM companies moving forward.

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Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On March 19, 2014, at 3:25 PM, bigjohn327 wrote:

    the statement that"80 percent of distributors have sales higher than their sponsors" says a lot to me says that the real goal is for you to sponsor and not sell. also that many become distributors to get the discount means lots of in house sales of product and not retail sales

  • Report this Comment On March 19, 2014, at 4:46 PM, kint wrote:

    Questionable business models may not be illegal, but questionable business practices are. If Herbalife isn't disclosing that 88% of distributors don't earn a penny, they are deceiving them into thinking that they can earn commissions. This is like predatory lending, except it's predatory enticement.

  • Report this Comment On March 19, 2014, at 4:56 PM, justsayin wrote:

    OK, I got it - HLF may or may not be a pyramid scheme. Got any other actionable information?

  • Report this Comment On March 19, 2014, at 6:09 PM, daniel123 wrote:

    All the money is at the top, in the hands of just a few huh? Mostly controlled by the top one percent? Never heard of that before. Lets setup some tents downtown and protest. It must be illegal.

  • Report this Comment On March 20, 2014, at 7:52 AM, thestreethero wrote:

    I wish all the MLM companies go away. If 80% of the people tend to fail than succeed then let the people find the real job with the real earning.

    Get rich quick schemes are always deceiving.

    Herbalife is a cut throat company, it charge their distributors an arm and a leg for shipping thus even those that qualified for 50% retail sale profit, they aren't not truly getting it once minus the shipping and handling charges by the company.

  • Report this Comment On March 20, 2014, at 1:29 PM, ibarz wrote:

    What's sad about these 'questionable' business practices are that they target the low income and desperate individuals.

    If you've studied your high school math diligently, you won't get near any of these MLM. Sadly, not many people do.

  • Report this Comment On March 22, 2014, at 4:41 AM, success14 wrote:

    I'll e glad when Bill Ackman goes away. This whole thing has added quite a bit of drama but what no one seems to care about is the actual little guy that Ackman pretends he wants to protect. The little guy who can start a Herbalife business for a few bucks and turn it into a profitable enterprise like the lady in Mexico who started with a dollar and became one of Herbalife's millionaire's. For some reason we never hear anything about these people and they are out there.

    By the way, Herbalife does provide full disclosure on income so they are hiding nothing.

    Based on the comments on this thread, it is apparent that most people have very little if any real business experience.

    As for math, I had a math expert pull out a slide rule and prove why mlm will not and cannot work. I pulled out some bonus checks and showed him why it can, does and is working. People are suffering from paralysis by analysis.

    The best example is the guy working two full time jobs, still can't pay his bills and says Herbalife is a scam??? LOL.!!!!!!!

  • Report this Comment On March 22, 2014, at 4:44 AM, success14 wrote:

    How Valid Are Bill Ackman’s Claims that Herbalife Is a Pyramid Scheme? About as valid as the people who told Christopher Columbus that the world is square and if you sail to the end, you will fall off. Soon the myths about Herbalife will become as invalid as the one with Christopher Columbus.

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Matthew Pelletier

Matt Pelletier is a recent graduate who has always had an interest in the market. Since starting life in the real world, Matt has expanded his investing and loves a good value stock. He enjoys investing in Industrial and Technology stocks and he considers a 10-K as light reading. All opinions and analysis are his own.

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