Beware the bad business model: when good business intentions go bad

Why do some legitimate businesses turn into scams? Often, it’s because of a bad business model.

Some scams start out as scams, with the perpetrator having criminal intent from the off. Others start out as a bona fide business built on a bad business model. Some scams even evolve from a good business model that has turned bad because of bad business decisions or complacency.

The origins of the scam don’t really matter. What matters is the result: a lot of people losing a lot of money. However, let’s take a few moments to discover how these scams do differ.

The classic property investment scam is when the perpetrator deliberately sets out to steal investors’ money.

You may have heard the term Ponzi scheme. This type of scam starts with absolutely no more than a promise. Investors’ money is used to feed previous investors their promised return, with the scammer skimming the remainder. The majority of investors in this type of scheme lose everything.

What is a Ponzi scheme?

  • The Ponzi scheme is named after Charles Ponzi who, in the 1920s, promised investors an incredible 50% return on their money in 45 days, or 100% in 90 days.
  •  The investment vehicle was published as international postal coupons, but he never bought a single one.
  • Early investors received the promised return, thus providing evidence to substantiate his guarantees.
  • Six months after starting the scheme, Ponzi had absconded with £10 million of investors’ money.
  • After serving his jail term, Ponzi launched another investment scheme. This time he was selling worthless real estate. Unsurprisingly, he was jailed for a second time.
Misleading details and misdescriptions

One distinction that I want to make now is that  I am not going to mention all the schemes where the details are oversold, are misleading, misdescribed or otherwise; they are legitimate schemes with a mild sting in the tail. Mild compared to the scams we are talking about but none the less unwanted.  

Legitimate businesses built on a bad business model

The scam that evolves from a legitimate business is more difficult to detect. The business starts out with good intentions, and its promised returns are made to begin with.

Things appear to be going well, but then something happens to upset the apple cart. Often, this is because of a lack of experience; but it might also be simply that market conditions alter so dramatically that the original business model crashes. Losses build up, but rather than admit problems to investors, the business controller carries on regardless.

In order to do this, he or she needs more money from investors, and the once legitimate business morphs into a Ponzi scheme. Of course, eventually the business goes belly-up and all the investors lose their money.

Bernie Madoff’s Ponzi scheme: When good businesses go bad

  • Bernie Madoff’s wealth management business started out as a legitimate concern. It made good money for investors. But then Madoff got greedy and turned the whole operation into a giant Ponzi scheme.
  • Investment returns faltered, but he started taking more and more himself. His lies and scheming eventually unraveled. The 150-year prison sentence meted out to him will be little reward to the investors that he swindled out of £45 billion.

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Brett Alegre-Wood
May 18, 2016

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