Before I went away I left people a puzzle - to force people to understand the Herbalife compensation scheme.

The puzzle was - and to quote:

Imagine you were the very first Herbalife distributor and you recruited three people and they - eventually and through their downline - recruited the millions of people who now consume and/or distribute Herbalife. 

And also presume you did nothing else for the rest of your career. You just sat there and collected the "recruitment rewards" or the "royalty checks". 

Roughly how big would your income be now? And from how many levels would you be collecting your income?

The reason that I posted this puzzle was that short-sellers (broadly defined but starting with Bill Ackman's original Herbalife presentation) have publicly said many false things about Herbalife - and one area of these falsehoods has been the remuneration scheme.

Specifically Ackman thinks that the scheme is designed to push large purchases of unsellable weight loss powder and enrich Herbalife and top distributors while defauding mostly poor Latinos.

And the guesses I have received for the answer conform to this suggestion. The typical guess was about $3-5 million per year. Christine Richard - one of the key outsource researchers for Bill Ackman was in the middle of that range (at $300,000 per month). I got one estimate of upward of $50 million per year.

These estimates are based on a false assumption - an assumption promulgated by Bill Ackman. The assumption is that Herbalife's compensation scheme is a conspiracy to enrich top distributors at the expense of middle and low level distributors.

This is to misunderstand the motivations of Mark Hughes who founded Herbalife.

Mark Hughes is a character about whom people have strong opinion. I have seen everything from a flat-out man-crush to utter revulsion. But whatever you say about him you have to confess he was a clever businessman.

He invented a monstrously complicated compensation system for Herbalife distributors - and it was invented to benefit his company and not the early distributors. He did not wake up one morning and say I will make these early distributors rich for life for just sitting around.

Mark Hughes wanted Herbalife to sell a lot of product. He did not want to pay distributors to sit around and do nothing. Indeed the scheme is designed so that if you do not stay active selling your income eventually tails towards zero.

Here is how the scheme actually works (and this is a simplification but these are the core ideas).
 

If you are a base level distributor you buy the product at a discount of up to 42 percent. You sell it at retail. You make a margin. 

At some point you become a sales leader. A sales leader is entitled to buy it at up to 50 percent discount. You can NEVER buy the product at a higher discount than 50 percent. 

But the sales leader is entitled to a royalty. The royalty is paid three levels deep. A recruits B recruits C recruits D recruits E then A is entitled to 5% of BCD but not E's sales. B is entititled to 5% of CDE sales. That way 15 percent more is paid out. 

This you are always entitled to - three levels deep.

After that there is a "production bonus". These are up to 7% of sales based on your level. However if someone in your down-line earns 2% production bonus then you are only entitled to 5%. And when your down-line is long and successful enough the entire 7% will be earned below you. You will be blocked and receive no income.

After that and if you are senior enough you may receive the Mark Hughes Bonus - typically 1% of all sales paid infinitely deep in the sales structure. HOWEVER if someone in the Chairman's Club is below you (and this happens) then you get blocked on that too. So you will receive no Mark Hughes bonus. 

The person I describe could never be in the Chairman's Club (to do that you need 5 people below you to make a certain level) but someone who was very early and has done almost no recruiting will almost entirely be blocked on the Chairman's Club as well.

So lets calculated the answer...

They do no sales - so they get no retail discount.

They have people three levels below them - so they receive 5% of their production - but their immediate network is either senior and doing few sales or sclerotic). This is the only income they get - and it is 5% of three levels. 

They are unequivocally blocked on the "production bonus" so they get nothing there and
They are not Chairman's Club or above because they recruited only three people - and if the recruited more they would be blocked for most of it anyway just because the very early guys have all been blocked out unless they kept growing their network. 

So all they get is 5% of three levels down - which is likely to trivial - probably less than $5000 a year.

Note the 50% plus the 15% plus the 7% plus the 1% is the famous 73% payout ratio. It all gets paid - just not to the foundation recruiter. In fact it gets paid to people they recruited, people who worked hard to build networks and make more sales.

The scheme is deliberately designed to reward active people who are growing their network not old codgers at the top. It is complex I will concede - but the complexity is designed to do almost precisely the opposite of what Bill Ackman claims it is designed to do.

How did the Ackman crowd - including Christine Richard get this so wrong?

According to the Wall Street Journal Bill Ackman's researchers are currently getting investigated for (possibly) lying to investigators about Herbalife.

And they have told untruths about the Herbalife compensation scheme.

But the scheme is complicated - and they looked at the scheme and saw what they wanted to see (ie evidence of a pyramid scheme benefiting the very top) and not what is actually there (a scheme designed to incent sales).

This was self deception - but it was self-deception aided by some Herbalife distributors who say you can build "residual income" by recruiting a large network. When distributors talk about sustained residual income they are not telling the truth.

Still there are resources on the web that help you understand it. There is one distributor who is trying to sell MLMs that are not Herbalife - arguing that there is a "flaw" in the Herbalife system that denies you residual income. They want to sell you an MLM that really is a pyramid. To quote...

Now it’s down to infinity until the next level ranking Distributor at your level reaches your level. So if I’m a President’s Team member or a Millionaire Team member and I have somebody underneath me that hits Millionaire Team member, then I’m blocked off of that production bonus.

Now how the production bonus works with the Herbalife Compensation Plan is let’s say I’m a GET Team member and I have 20,000 organizational volume points, I get a 2 percent production bonus.  I’m going to get 2 percent all the way down to infinity until somebody reaches the GET Team status underneath me. Once they reach the GET Team status underneath me and if I’m GET Team myself, not advancing to Millionaire Team status yet, let’s use that as an example, then I would be cut off or the breakaway of my production bonus would take place.

So the only time that you earn production bonus is when people are not at the same level as you. So if I’m a President’s Team member and I am earning a 6 percent production bonus, and I have somebody underneath me and my team that is a Millionaire Team status, the Millionaire Team status member would get the 4 percent production bonus and I would get 2 percent because there’s a total of 6 percent paid out, and that 2 percent production bonus I would earn until that person reaches the same rank. In the example, if I was President’s Team, once they reach President’s Team, I would be cut off from that production bonus.

One of my main things that we teach here at XXX is that you should never be penalized for developing leadership. You never should be in the fear that your income is going to drop based on someone advancing to a higher rank.

This is one of the key reasons of course why Herbalife is not a pyramid scheme. Any new member can reach the higher level - though very few do. It is really hard to develop an organisation that sells hundreds of thousands of dollars worth of Herbalife per month. Though every month in the US a few more people get inducted into the President's Team. And every month upper level distributors have their income reduced somewhat.

This is not the pyramid scheme Bill Ackman told us about.

John