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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Matthew Pelletier has no position in any stocks mentioned. The Motley Fool has the following options: long January 2015 $50 calls on Herbalife. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.