Many of us have been taught since birth that there’€™s no such thing as a free lunch, and that if we want something, the best was to get it is to work hard for it. Another lesson from early childhood is the adage, “œIf it’€™s too good to be true, it probably is.”

Why, then, as adults, do so many people suspend their disbelief and get ensnared in a variety of scams, ranging from pyramid schemes and chain letters to Ponzi schemes and other High Yield Investment Programs? (These are known as HYIP programs, for short.)

I will present a method here that can be used to clearly identify mathematically unsustainable business models, otherwise known as scams.

People have posed this question: “Why, after all this time, do we still not have SOMETHING in to help us separate the wheat from the chaff when it comes to Internet Businesses and other investment opportunities?” The Black Box Method is the tool to answer that question. Before investing in any enterprise, it is the responsibility of prospective investors to do their own due diligence, and not rely solely on the advice of friends, colleagues, and relatives (sadly, those connections are frequently leveraged by scammers as part of affinity fraud). Part of the due diligence process is to examine the opportunity for mathematical viability, and the Black Box Method is an easy tool to carry out that analysis.

Mathematical sustainability means that a business can continue indefinitely, i.e., it is a viable long-term enterprise. All scams that I am aware of can be shown to be mathematically unsustainable.

However, short-term un-sustainability is not a problem provided that long-term sustainability can be shown (most businesses when starting up go through an initial investment phase that appears to be unsustainable.) The key to the analysis is to look at sufficiently long times to see whether or not the business model breaks down.

THE BLACK BOX METHOD

The Black Box Method can be used in many different situations, and can be used to analyze virtually any process or business model. The tool comes from the field of process design and control, and is a standard tool taught at advanced levels in chemical and process engineering. It is also commonly applied in computer science, and in finance, and has been used successfully for decades.

Consider first a complex chemical reactor, such as a catalytic cracker used to break down crude oil into a variety of lower-molecular-weight components, including gasoline. In such a reactor, there are dozens, if not hundreds, of different chemical reactions occurring simultaneously within the reactor. It is not possible to understand each and every reaction, nor can one track those individual reactions. Instead, the overall process is modeled using the Black Box Method. For chemical reactors, the method relies on the principles of conservation of mass and conservation of energy. Rather than trying to understand all of the chemical reactions that are occurring, we consider the overall reactor system of pumps, reactors, values, etc. as a Black Box.

We cannot see into the Black Box to see the inner details of what is happening, but that is exactly the point. When we apply the conservation principles to the Black Box, examining all of the inputs and outputs, we are able to learn a lot about the system. The oil industry in fact does this, and is able to effectively manage the catalytic cracking process. The key learning is that IT DOES NOT MATTER WHAT HAPPENS INSIDE THE BLACK BOX. All that matters are the respective inputs and outputs.

Similar methods are used throughout the oil refining industry, the chemical industry, and the biochemical industry. The Black Box Method is a well-established tool used to understand trillions of dollars annually of production materials that go into things we use in everyday life.

For the purpose of evaluating business opportunities and investments, we can again use the Black Box Method. Consider any business model. All of the activities of the business model occur within the Black Box. We don’€™t care at all exactly what happens within the Black Box. All we care about are the inputs and outputs to the Black Box (inputs and outputs to the business). We rely on the principle of conservation of money to do the analysis.

I will use as an example the business model for Ad Surf Daily, which the US Government has alleged is an online Ponzi scheme and was shut down in August 2008.

Various ASD supporters have made various claims since the shutdown of ASD along the lines that €œAssistant United States Attorney General Cowden did not understand the ASD business model, nor did Judge Collyer. If they did understand the model, they would recognize what a brilliant business model it really is.€

Other supporters have proclaimed Andy Bowdoin a genius for developing a unique, new Internet business model, but acknowledge that it is €œso complex, only Andy really knows how it works.€ Still others have pointed out that the ASD business model is thoroughly explained in a 105-page document that provides the necessary details (but of course is too complicated for Mr. Cowden and Judge Collyer, let alone the average person, to understand).

It must be noted that scammers try very hard to make their business model seem somehow magical, unique, and complicated. They try very hard to make things complicated enough that a sufficient number of people will not do their due diligence and wade through the complexities but instead will put their money into a program.

In the case of ASD, the money put into the scheme was relabeled as a purchase of €œ”Ad Packs”€; these “€œAd Packs”€ were priced at $1 apiece. Members then received “€œrebates”€ for viewing online ads of other members (the Ad Packs of those other members) based roughly on the number of Ad Packs that they had purchased. Members were also encouraged to sign up others (friends, neighbors, colleagues, relatives, etc.) to be part of their €œdownline,€ and they received additional “€œrebates”€ based on the contributions of their first-level and second-level downline members.

It was very common for members to reinvest their rebates into more Ad Packs, ostensibly in order to compound the earnings that they would eventually receive. ASD would also occasionally offer “€œmatching Ad Packs”,€ enabling members to get 2-for-1 on the Ad Packs. All of this lexicon and all of these complexities were designed to mislead prospective investors as to what they were really getting involved with, which as this is written is being judged by the government as a Ponzi scheme, much like a number of similar previous schemes such as 12DailyPro and Phoenixsurf.

The ultimate fate of the ASD case has yet to be finally determined in court, but if history is a guide, ASD will soon follow the path of 12DailyPro. The beauty of the Black Box Method is that we don’€™t really care about the inner workings of the business model. All we really need to do is look at inputs and outputs, integrated over time.

In the case of ASD, you don’€™t need to fully understand the workings of Ad Pack purchases and repurchases and multilevel rebates to analyze the business model.

STEPS

The first step in the analysis is to consider the whole business process as a Black Box. We do not need to understand all of the gyrations of the business model in order to analyze it, we need simply to add up all of the inputs and outputs over time into the Black Box and see what that analysis reveals.

Conservation principles state that the inputs equal the outputs plus the change in the state of the black box. Generally we are analyzing steady state processes, or equivalently, viable long-term businesses, which means that the state of the Black Box is unchanging. (Think of the earlier example of the chemical reactor – you cannot indefinitely build up material inside the reactor, so inputs = outputs).

However, over short time frames, the state of the Black Box can change due to fluctuations in cash flow (all businesses experience this day-to-day fluctuation due to fluctuations in daily sales, payroll dates, rent due dates, and a host of other cash flow timing issues). However, in the long term, the Black Box must have a stable state.

I want to re-emphasize that it is very important to understand the idea of adding up all of the components over time. One can achieve any slant on the results by looking at the inputs and outputs over very short periods of time.

Take a retail business that sells watches as an example. The Black Box is the business of selling watches. The inputs are the sales dollars, and the outputs are dollars paid to the watch supplier, dollars sent to the bank account of the store owner (their profit), and the dollars spent to run the business (wages, utilities, rent, etc.)

On any given day, the Black Box analysis can look very good (lots of watches sold, so lots of dollars in the input) or very bad (the day that the watches are paid for, especially if no watches are sold). This instantaneous analysis even applies if EVERY watch is sold at a loss – some days can look like they are good days.

What the store cannot do sustainably is to sell watches at a loss. It is the summation over time that shows this to be the case.

Scammers also make use of short-term sustainability in trying to convince people to invest in their scam. All €œ”good”€ Ponzi schemes do pay off some of the early participants; otherwise no one would ever invest in them. With ASD, some supporters have stated that €œeveryone has been paid, so how is ASD a Ponzi?€ The scammers use the sleight of hand of paying off early entrants in order to convince a much larger pool of late entrants that the business model is new, revolutionary, AND SUSTAINABLE. However, this is just an illusion. The condition of long-term sustainability is not present, even when the short-term numbers look good.

ANALYSIS OF ASD: THE BLACK BOX METHOD

Now let’s analyze the ASD business model using the Black Box Method. Remember that it does not matter what occurs within the black box in terms of things like purchasing ad packs, reinvesting virtual rebates in more ad packs, etc. All that matters are the cash inputs and outputs. The cash flow balance for the ASD black box is simply
Sum over time of cash flows in = Sum over time of cash flows out.

So, what are the cash inflows?

  1. Real “€œAd Pack”€ purchases from new and existing members (subsequent Ad Pack ‘€œpurchases’€ with rebate credits don’€™t count here – they only occur inside of the Black Box and so don’€™t matter. All that matters are REAL cash flows into the black box).
  2. Revenue from advertisers that pay to advertise on ASD’€™s web sites (the “€œmajor advertisers”€ alluded to by ASD supporters). The evidence so far is that this amount is zero or very small. If it were large, ASD could easily have the Ponzi charges dismissed.
  3. Initial or ongoing capital investments by the company founders or venture capital investors. Did Andy Bowdoin start ASD with, say, $100 million of his own cash? No proof one way or the other I suppose, but no one has seen the audited books of ASD. (one of the benefits of being a private, solely owned company).
  4. Other revenue from sales of products (again, no evidence for any significant revenue from this source).

So, it appears very likely that ALL of the cash inflows come from member ad purchases. The government alleges this in their filings, and ASD has yet to deny this allegation (or provide evidence to the contrary).

What are the cash outflows?

  1. Rebates to members.
  2. Operating expenses (salary/benefits, utilities, rent, etc.).
  3. Profit to ASD and hence sent to ASD’€™s bank accounts (which has been determined to be only Andy Bowdoin’€™s personal bank accounts).

Another condition of the ASD business model is that ASD kept 50% of all revenue for the operation of the company and for the profit for the owners. So now the steady state Black Box equation above simplifies to:

Sum of cash flows in = Sum of rebates to members (50%) + Sum of funds kept by ASD (50%)

The inevitable conclusion is that over a period of time, only 50% of the money paid in by the members gets redistributed back to the members. Let me repeat: The collection of members in total only gets half of their collective input money back over time. This is very different that what the majority of ASD members were expecting, and were led to believe. The promoters of ASD pitched 125% return on your “€œAd Pack purchases”€ as a minimum return (and higher with matching Ad Pack offers as well as downline commissions), couched in the statement “but your returns are not guaranteed,€ all the while touting how many members were making money and claiming that everyone is getting paid.

Thus the Black Box Method shows that the actual return to ASD members is 50% of what they put in (in other words, the AVERAGE member would lose half of their investment), while the promoters were claiming 125%, demonstrating that ASD is not sustainable mathematically over time.

How many people would have joined ASD if the promoters had said, €œGive us $1,000, and we’€™ll give you back $500 and keep $500 for ourselves?€ Not very many, I would guess. How about if they would add, €œYou can get back more than the $500, but we still get our $500? Anything else that you get over $500 means that someone else will lose more than $500.€

Well, guess what, folks? That is exactly the ASD business model.

This is of course based on two key assumptions. The first is that the owners are unwilling to put immense amounts of their own cash into the business for a very long period of time, and no one actually does that without a clear long-term payout. The second assumption is that there is no other significant stream of cash flows into the company other than ad purchases by members (old and new). One possibility would be if a national advertiser, such as if P&G, were willing to spend millions per month advertising on ASD and not be interested in the rebates that every other ASD member was hoping for.

Large advertisers are not that naive. If ASD was real, they’€™d want the “€œrebates”€ just like every other member. There is no evidence thus far that any revenue stream of significance existed for ASD other than member Ad Pack purchases. If there were, it would have been a simple matter for the attorneys for ASD to present such evidence in front of Judge Collyer and get the whole matter dismissed. They didn’€™t even try this obvious approach.

For sure, in ASD there were individual “€œwinners”€ (early entrants who essentially took the money of the late entrants) and individual losers (late entrants generally), but still the “€œaverage”€ member will only get 50% of their initial investment back.

WHAT WOULD MAKE ASD SUSTAINABLE?

We can also use the Black Box Method to show how much revenue from external sources is needed in order to achieve minimal sustainability. For ASD this is quite simple. Assume that ASD gets 50% of all revenue. Also assume for simplicity’€™s sake that we can ignore the first and second level downline commissions. Let’€™s just stick with the 125% rebate. The BB output is now allocated as:

  1. 125 parts of the total revenue input to the Black Box paid to ASD for expenses and profit.
  2. 125 parts of the total revenue input to the Black Box paid back to members.

The inputs to the Black Box are:

  1. Member ad pack purchases of 100 parts.
  2. External revenue from (say) major national advertisers of X parts.

It is easy to see that X = 150 from the fact that inputs and outputs must balance. Thus, for minimal sustainability, ASD needs 1.5 times as much revenue from outside sources like national advertisers than it generates from net member ad pack sales (remember, repurchases with “rebate money in the bank€ don’€™t count).

Further, those national advertisers would need to choose to NOT want the rebates that the members get.

When ASD was shut down, $93 million was seized from the private accounts of Andy Bowdoin. This all came from member Ad Pack purchases, according to the government. In order to be sustainable, at a minimum ASD would need $140 MM in external profits in order to cover the liability of the $93 MM in Ad Packs at 125% rebate.

THE MADOFF CASE

In principle, the Black Box Method can be used to analyze the sad story of the Bernard Madoff Ponzi scheme. The result would be the same, however.

Madoff promised to deliver a high rate of return on investments placed with him, rates that exceeded the typical equities portfolio but not by a great deal. On paper, he “€œdelivered”€ those high rates of return.

In practice the Black Box analysis would be a very difficult thing to do, mainly because of the lack of transparency with respect to the investment models of Madoff. Another trick used by scammers is to “keep secret”€ their proprietary business models. Doing so prevents individuals from being able to perform their due diligence analysis. The keys to the longevity of the Madoff Ponzi are:

  1. No transparency as to the actual working of the investment model, i.e. insufficient disclosure of what investments Madoff made on behalf of his investors. This prevents a careful Black Box analysis.
  2. Rates of return that are not wildly out of line with normal market returns (as opposed to ASD, pyramid schemes, HYIP’s etc.). This very attractive, but still “€œbelievable”€ rate of return enables the Ponzi scheme to last for a very long period of time and get very big. Obvious Ponzi’€™s such as ASD, and the emerging Ad View Global, cannot last for very long nor get big (relative to Madoff). Let’s classify the Ponzi schemes into Fast Ponzi schemes and Slow Ponzi schemes.
  3. Madoff mostly had large investors and foundations for his clients. These investors are more of the buy-and-hold persuasion, and so did not frequently request money out of their investments. Rather, they were content to read their monthly statements, watching their investments “€œgrow”€, and occasionally taking out small amounts. Fast Ponzi schemes on the other hand rely on large numbers of small investors.

So, there you have it. The Black Box Method is an irrefutable measure of the sustainability of any business model or enterprise. Apply it to any opportunity you encounter. A simple case study, left to the reader, is to analyze a Gifting program, pyramid scheme or chain letter (the now-common “€œGifting”€ programs are just very simple pyramid schemes and illegal).

The sums of the cash flows must balance into the Black Box and out of the Black Box. If they do not balance, the opportunity is a scam. One important corollary to Black Box sustainability is that it does not matter, more or less, when you invest in the opportunity.

People who urge you to “€œnot miss an opportunity€” and to €œ”be sure to get in early” are likely to be recommending a scam. Also look at the inputs to see where the money you expect to make is coming from. Is it coming from real business value creation? Good€¦.. Is it coming from other member’€™s money? For virtually all scams, this is where the payout is coming from.