Wednesday, March 18, 2015

The Herbalife compensation puzzle

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.



Anonymous said...

"Mark Setforth was the mastermind behind the original Herbalife Comp Plan, and owned the company which manufactured Herbalife products for years."

Anonymous said...

Fabulous work.

Anonymous said...

When you're proven right, I am going to buy an LA Galaxy Herbalife jersey and take a picture of myself wearing it in front Ackman's beloved General Growth Properties building on the Chicago River.

Jonathan said...

Thanks, John. Any update on what you think is happening with significant changes in the share registry?

Anonymous said...

Why didn't the company itself give a rebuttal by explaining how the organization works?

Anonymous said...


I don't see how this is relevant: the incentive is that they must keep recruiting. That is why some top distributors leave to go to other MLMs where they don't get cut off from the production bonus.

I think there are enough videos out there of top distributors showing that this is how the scheme really works, in practice. Also, most distributors likely don't realize they will be cut off from production bonuses initially. Keep in mind the Burn Lounge comp plan was a rip off of the HLF plan for the most part (I'll need to double check this as I'm basing it off of a 3rd party). They just lacked the nutrition club model.

Lastly, regarding incentives: how can one reliably sell a commodity at an inflated price to earn a retail margin? Most won't be able to unless they offer ancillary services for free along with the product. Unless you can earn a decent profit off of one nutrition club, then you must recruit. HLF docs emphasize "duplication" of the nutrition club model according to docs that Ackman posted (whether or not you believe those are legit is another story).

Thanks for the puzzle. I'm just not on the same page regarding its meaning...

Kevin S

Anonymous said...

This is all very interesting.

But it does not address the key legal question: Does the majority of income come from product sales or fees from distributors?

Anonymous said...

Anyone else see the irony in the fact that a Herbalife bull calls the compensation plan a puzzle that needs to be solved in order to understand the business model. While at the same time making people believe that Herbalife should not be on the hook for all the financially unsophisticated distributors that they target because all the info is in a 100 pages of legal disclaimers.

Anonymous said...


I'm not sure if you are subconsciously or willfully contorting the facts into this narrative but either way, you remain tragically (and quite publicly) confused as to what this company is about. Let's boil it down to two fundamental questions. 1) Would a legitimate company interested in retail sales allow and actually encourage unlimited numbers of distributors competing without any geographic limitations and 2) why won't the company disclose the retail sales numbers (which the 1986 CA case requires them to keep) and just put the whole thing to bed if they in fact show its not a pyramid? I think we both know the answers and in fact, I don't believe you are still in the stock. I think you've seen the light like Chapman did and got flat but for some reason you remain on this crusade. Sad. And eventually very embarrassing.

Anonymous said...

Your explanation falls apart if most of the people buying the product are people new to the program, who load up on inventory and then fail and drop out.

In which case, you just keep recruiting more people, getting a royalty on their purchases until they drop out, too. Repeat.

Nick said...

It is very important to note that there is a very big difference between a complicated not very good business and a genuine pyramid scheme: one is perfectly legal!

Anonymous said...

Can we all agree that this CREW thing is ridiculous? Equating Eisman with Ackman and Shkreli is ignorant and uninformed. The problem with Ackman's campaign is that it gives a bad name to other short-sellers.

shb600 said...

What percentage of HLF's distributor's do you think make money? If it is not nearly all of the them then how will HLF keep their business model going? HLF's "stores" appear to be important. How are they not going to eventually have major problems like WTW has experienced in their meetings? The product appears to be very expensive vs. other weight-loss products and consumers appear to be shifting to apps.

Mak said...

John, now that you've cracked the Herbalife compensation scheme, your next challenge is to crack the Global Strategy Group compensation scheme for manufacturing evidence against Herbalife.

Anonymous said...

John...if Ackman (and others for that matter) are so wrongly characterizing the business model, maligning the methods (even you called them scumbags)and damaging the value of their business as a result, isn't the board's and management's fiduciary duty to sue in defense of the business? They are no strangers to litigation (admittedly, usually as defendant, not plaintiff)and have the resources. Why aren't they suing the pants off those portraying them in great detail as a pyramid scheme?

Anonymous said...

John - Still, the marketing plan that you described focuses on recruiting and a business opportunity on the product. That's the core of the issue. Simple question - how much revenue is earned outside of the herbalife circle from selling the product?

Anonymous said...

I was watching Michael Lewis on CNBC this morning, discuss his book Flash Boys and how the market is (in his words) "rigged". He made an interesting comment (I thought)... The new fraud is near overwhelming complexity; it's at the root of modern bad behavior. Witness not just the High Frequency Trading, but Subprime meltdown (who could understand what was really in a CDO squared? We were actually told we needed to retain the wolves who created them to help unwind or sell them! ANd pay bonuses, to boot.) The Herbalife Comp Plan (MLM industry maybe) was ahead of its time. It is designed to confuse; to divert attention; to get YOU (John Hempton) and others distracted and wasting time spinning your wheels debating circular issues. The Nutrition Clubs are similar in their partial design to confuse and distract, create the illusion of retail sales, when it is conscripted consumption of product by striving participants and their friends & family & potential recruits (BurnLounge appeal asked: would the retail sale have occurred but for the business opportunity?) The vast majority of Nutrition Clubs do not qualify as retail sales because the case law (FTC v FutureNet) says "compensation related to recruitment is ANY form of compensation that is conditioned upon, derived from or RELATED TO recruitment of new persons to any business opportunity... including but not limited to any type of TRAINING to either new or existing participants..." (emphasis added)

Omnitrition Comp Plan was a knock off of HerbaLife (Jorge Vergara was an early Herbalife distributor who realized he didn't want to sell so hard for Mark Hughes, wanted to own his own pyramid scheme outside the reach of US authorities)

BurnLounge decision said nothing about "blocking". It did say over and over and over: (What is the Motivation & Incentive?

You (John Hempton) made the case for Pyramid conviction. The overwhelming Motivation & Incentive is to Recruit, Recruit, Recruit. It is the ONLY way to succeed in Herbalife and advance in the Comp Plan. Herbalife is a fraudulent pyramid scheme. You explained it very well. You got confused, as you admitted it is confusing.

What's really important is to simplify. Understanding Herbalife would be improved immensely by eliminating the extraneous, the noise. Not everything that's knowable is worth knowing. Strive for simplicity.

Tom Salvatore

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