World Changers

In 1997, Reed Hastings had rented the movie Apollo 13, misplaced it, and forgotten to return the VHS by its due date. Six weeks later, when he finally brought the videocassette back to the rental store, he owed a late fee of $40. “It was no one’s fault except my own,” he recalls.

When he got back home, he quickly fessed up—and then he began thinking about the Internet, a new emerging technology—DVD—about to replace bulky VHS tapes, and how a business might be able to work without those damn late fees.

The idea became an obsession. On his way to work out one day, it occurred to Hastings that his gym had a much better business model than his video rental store: you pay $30 to $40 a month and exercise as little or as much as you want.

Suddenly, all the thoughts began crashing together. Would it be possible to create a movie-rental business by mail, abolish all late fees, and ask customers to pay monthly subscription fees as if they were members of a fitness club?

Within days, Hastings ran out to Tower Records in Santa Cruz, bought a few audio CDs, stashed them into envelopes, and then mailed the pieces of plastic to himself. “It was a long twenty-four hours until the mail arrived back at my house,” Hastings recalls. “I ripped them open and they were all in great shape. That was the big excitement point.”

The person who had conducted this little experiment had already founded and sold one company for $750 million—in the same year he paid the $40 in late fees. He had also sold vacuum cleaners door-to-door, had trained as a Marine officer, and had taught algebra and geometry in northwest Swaziland, where he lived in a thatched hut and slept on a cot as a member of the Peace Corps. “Once you have hitchhiked across Africa with ten bucks in your pocket, starting a business doesn’t seem too intimidating,” he says.

It was while he was in the Peace Corps in 1985 that Hastings decided to get a graduate degree in computer science. He had majored in math at Bowdoin College, finding the abstractions “beautiful and engaging.” Originally from Boston, he wanted to go to MIT. But the school turned him down. Instead, Hastings got an invite from Stanford University. “I had never been to California and arrived in late summer,” he remembers. “Driving up to the campus I saw palm trees. It was dry and brown. I asked myself, ‘Where’s the ivy?’ But within a week, I had fallen in love with California.”

His first job out of Stanford was at Adaptive Technology, where he invented a tool for debugging software, but Hastings left in 1991 after three years to found Pure Software, a company that produced products to troubleshoot software. For a thirty-one-year-old engineer with no management experience, he found himself ill equipped to deal with the challenges that make their way into a CEO’s office.

“As the company grew from 10 to 40 to 120 to 320 to 640 employees, I found I was definitely underwater and over my head,” Hastings says. “I was doing white-water kayaking at the time, and in kayaking if you stare and focus on the problem you are much more likely to hit danger. I focused on the safe water and what I wanted to happen. I didn’t listen to the skeptics.” Twice, after losing confidence, he tried to fire himself as the CEO. But the board wouldn’t let him go. Revenues were doubling every year, and Hastings learned how to become a true entrepreneur. By 1995, he had taken the company public. Two years later, he sold it to Rational Software for $750 million.

So when Hastings got the idea for his new movie-rental business, he also had the means to fund it. Good thing. Netflix lost money for four straight years before breaking into a profit in 2002, the year the company eventually went public. Hopes to do an IPO earlier were dashed by the dot-com bust, which Hastings failed to foresee. “It’s hard to know when you’re inside a bubble,” he says. It was a difficult period, a time when Hastings had to tell his employees, “Tomorrow when you come to work, if what you do isn’t making the customer happy, moving the business forward, and saving us money, don’t do it. Everything we do has to meet these three criteria.”

But the company has experienced one of those hockey stick trajectories that end up in business plans but rarely come true. In year one, Hastings signed up 239,000 subscribers. Today, Netflix has more than 24 million subscribers who pay at least $8.99 a month for access to its movie and TV show library. The company will surpass $3 billion in revenue in 2011 and likely have operating income in excess of half a billion dollars.

Hastings has changed how the entertainment business reaches its audience and how that audience is able to access content. His disruptive business model has survived a challenge from Walmart and also has vanquished Blockbuster, which was forced into bankruptcy reorganization in 2010 and sold at auction in April of 2011. It’s also successfully made the early transition from the U.S. Postal Service to streaming video into the home via computers, iPads, TVs, and game consoles. Shipments of DVDs are now declining as more users stream. And Time magazine named Hastings one of the one hundred most influential people this year of 2011.

I just forgot about it. The point is I remember it so clearly because I didn’t want to tell my wife about it. “My God,” I thought, “I’m thinking about lying to my wife.” That was one of the big influences. As the Internet grew, I thought there was a market for doing online movie rentals.

At first we looked at the business as VHS by mail. And the problem is a VHS tape cost about four bucks to mail, four bucks to mail back, and four bucks to rent. There was a pretty small market for $12 video rental. And then a friend told me about DVDs. “They’re just like CDs,” he said, “and DVDs are coming out next year,” but you couldn’t buy any yet. So we ran down to Tower Records and thought, “Wow, if you could mail them would they get destroyed? Or not?”

We bought a bunch of CDs, ran down to the post office, and mailed them to ourselves. Then we had to wait a day to see if our great idea would work or would we get all these broken shards. The next day the postman came and we opened them all up, and all the CDs were in perfect shape. And you could mail them for 36 cents then.

Did you have trouble selling the idea? You had a big monster called Blockbuster out there that essentially had the market for rental video all to itself. And in the dot-com era, mailing DVDs via the post office wasn’t exactly sexy.

The challenge in raising venture financing for Netflix is we were doing it in the bubble of’96, ’97, ’98, and ’99. At that point, everything was changing so fast that people said, “How is this going to work? We are going to be beaming movies to your watch in 2000?” This ridiculous stuff was getting funded, and it took us a long time to get funded because the idea was so practical. We did get some venture capitalists, and then the company grew and we eventually got profitable and went public in 2002.

Is the secret sauce customer service? That’s a little simplistic. Everyone tries for great customer service. Depending on what you do, it can be too expensive and unprofitable. There are edges that you have to figure out. You have to decide which customers make the most sense to best serve.

As an example, when we started with DVDs only, it was extremely expensive to have every new movie in stock during the first two months because there is a lot of demand for them. Three months later, it’s easy to have the movies in stock because there is not much demand. So we are always trying to manage to our costs versus the satisfaction of our customers. I don’t think it’s fair to just say all we do is salute the flag of customer service. We try to figure out where we can efficiently serve some sector of customers who are a little bit tolerant on new releases and love the vast catalog of a hundred thousand titles with overnight delivery. If there is a secret sauce, it is that we think very carefully and strategically about which set of customers to serve well. For those customers we are a blessed experience, but it’s more focused.

The relationship that people had with Netflix, especially in the early days, was that people turn it on for three months and then off and come back. Every fall we have huge numbers of signups and nobody leaves. And in the spring the churn rate is astronomical because people want to be outdoors. We get the reverse phenomenon in the hottest parts of the country. In winter, they’re more outside and people cancel.

So we have evolved to a place where churn is not a deathly thing that we work hard to prevent. In fact, in some way it’s a natural part of the rhythm of people. At one point, we had the typical AOL kind of exit. By that I mean, you click on the screen and up would pop a window that said, “No, you don’t really want to do that.” And then you would have to go through nineteen screens until it said, “Now call this number.” And then you call and it’s busy and you’re put on hold. It was an awful experience. We had that in ’02 and ’03. Then we decided to get rid of it and allow customers to leave with just a single click and the message: “Okay, thank you. We hope you come back again.” Because it’s so easy to exit and people have so much tension around that, they are much more likely to come back. So we have shifted to go with their flow as opposed to helping our subscription methods. We win them back with great service and selection. But that was a great lesson for us: making it as easy to cancel as it is to sign up.

Reed, you’re essentially a disrupter. You looked at the existing business model of movie rentals, figured out that users were frustrated by it, and then tapped into new technologies—the Internet and the switch from VHS tapes to DVDs—to invent a new model to upend a powerful incumbent player, Blockbuster. A lot of businesses are getting disrupted today. The obvious question, though, is why didn’t Blockbuster react as quickly as one would have thought to protect its business model?

Everyone wants to know when you miss a big thing coming. The facts are we launched our service in 1999, we went public in 2002, and Blockbuster didn’t enter against us until mid-2004, about five years after we started. The question is, did they wait too long? The answer is clearly yes.

But it’s actually much harder than it appears. It turned out that our threat turned into a big threat. But the game of business is like the game of chess. A master chess player doesn’t explore every possibility in brute force twenty moves out. He is constantly pruning and trying to figure out where the threats are. You follow a few potential sequences down to great depth. If you miss one and you prune a branch you shouldn’t have, you can get checkmated. So master chess players get very good at pruning which things could amount to real problems and which ones are not likely to. They’re not going to spend the time thinking about all the possibilities on the limited clock they have.

All the time, threats come up. People come to me and say, “Look at this new mobile device that goes off a satellite. It is going to transform the business.” I don’t think so. Most of business is about focus. We are good pruners. We prune the tree of possibilities down to some manageable set and then try to have our people execute on our core beliefs.

By and large, Blockbuster had actually done a fantastic job of pruning. When the bubble was there in’99 and 2000, and things started going crazy, their big competitor Hollywood Video wasted $400 million trying to sell VHS online. Blockbuster was much more disciplined. They did a great job. They actually were systematically good pruners.

They weren’t sitting down in Dallas smoking cigars saying, “Nah, Netflix didn’t matter.” They were very careful market researchers. They spent a lot of time interviewing our customers. They guessed at that point that we could get to maybe a million subscribers and then the market would saturate. Therefore, it was not worth their putting a lot of effort into it.

They turned out to be wrong. They just pruned the tree wrong. We got to a million, to four million, and we kept going. By the time we got to a million, they said, “We were wrong. We have to run after them.” It was just a slight error in judgment as opposed to being asleep at the switch. All of us in management are trying to figure out what to focus on and that is one of the core executive tasks. I think they just made one error on that.

They did put a dent on us. Our stock dropped from $39 to $9. That felt denty. The challenge that they had is, if you attack a company like ours, we had enough cash so we were unlikely to go bankrupt. We had nowhere to run. We had infinite exit costs. If you attack an area with infinite exit costs, it’s very expensive. They could hurt us, but all we would do is cut prices to survive. It ends up in mutual destruction, and that’s in fact what happened for a while. What they should have done is started a new model: the $1 kiosks in supermarkets and other stores that became Redbox’s business. That would have been an enormous new market opportunity.

So what they should have done is an end run around us. Instead of wasting money doing exactly what we did, they should have taken their $500 million of capital and invented a new market. Blockbuster would have been hugely successful. The lesson there is that if you duplicate someone who is already successful, your chance of profit is pretty low.

Of course, you built a model that you knew would eventually be disrupted itself. That’s why you called it Netflix and not “DVD by Mail.” So have you worried about someone else coming along to disrupt Netflix just as you did to Blockbuster?

The Internet is the disrupter. I’ve just been a stamp licker. Most of our volume and all of our profits came from mailing things to people. We were as afraid of the future as anyone else. We thought that the Internet broadband would allow streaming video that would eventually upend our business model. But we knew it was coming when we started. We’ve grown up with this thing as opposed to a scenario where we had a great profit stream and then something new comes along to disrupt that. But predicting the Internet and what will happen is impossible. No one I know would have predicted Facebook a few years ago.

Clearly, this connectivity that the Internet brings is a force that is as fundamental as the domestication of the horse, the advent of shipping, the railroads, and the automobile. Only it’s in a really compressed time frame. So it will happen over thirty years and everyone is going to have one hundred megabits, full streaming, high definition, two-way conversations over the Internet. When we get to full video interactivity that is immersive with avatars, the stuff that we faced over the last ten years will seem relatively trivial.

Typically, you might have two strategies if you are caught between a new technology that will render your product obsolete: you either milk the cow you own until it goes dry or you double down on a bet for the future. How do you come to that decision?

The most important thing is that you know if you are in double-down or in milk mode and all your constituencies agree that you’re in one or the other. The awful stuff happens when you go back and forth. You don’t want to be in a milk-the-cow mode because that sounds bad, but we’re not really prepared to invest. That is certainly not going to result in any good. In milk mode, you’ve got ten or fifteen years of steady profits and you organize the company for that. In double-down mode, you are essentially saying there is not much equity value left in your business model. We are going to take all the profit and be like a start-up and try to figure out the new world. If you get the backing to do that, it can be really fun. What’s not fun is half the company thinks you should double down and half the company is in milk mode. I will be lucky to figure it out in movies.

For a long time, our DVD shipments continued to grow as more video stores closed. That drove a lot of business online. We got to grow with that and then there is the streaming business where we offer all of our customers the ability to watch movies instantly on their laptop or on their TV I think it’s tremendously exciting because it is fundamentally lowering our mailing costs.

That doesn’t generate incremental profit at this point [Netflix has since moved to a new pricing plan that requires customers to pay for streaming]. It is a way to evolve people forward. What we have tensions on internally is there are all the people who work on the DVD business. They work really hard to make it a better and better service, and they feel somewhat devalued. And then we have all the people on the streaming side who are working really hard but they can’t believe that they have to go along with this DVD thing. So we do have those tensions.

Internally, we’ve had to clarify our strategy and tell people it’s necessary to improve the service by strengthening streaming and trimming DVD. And we had to explicitly give our internal groups permission to treat the DVD side as more in cash cow mode and that wasn’t anti to customer or anti to company because the overall service was improving, especially if you view the overall service as a combination of streaming and DVD. But that is a shift. A few years ago, we were in a pattern of maintaining (the DVD business) and doing something, and now we are in trim and do a lot. Overall, that creates a better customer experience, but it doesn’t create a better customer experience for every single customer.

Well, it’s more ambiguous for sure. The long-term competition in streaming is unclear. It’s not clear if it is Apple, Google, Hulu, or Amazon. It is a very small market and it will have a lot of competition. Whereas on the DVD side, it’s pretty clear the competition is Blockbuster and Redbox. So it’s a known set and it feels less scary. On the streaming side over the next ten years, it is going to be wildly competitive.

What is coming is a titanic battle between the forces of freedom and the forces of control. The forces of freedom want you to be able to select whatever content you want when you want. It’s the pure on-demand world driven by the Internet. The forces of control want to pick the programming that you see. You have so many channels. You have remote control. It’s two hundred to five hundred channels and they say, “You pick it.” Often when people look at this they say, “Well, this is biased. You’re calling it the forces of freedom and isn’t that always the natural winner?” But that’s not always true in business. Often the forces of control win because they can deliver a higher-quality experience. Every time you pick up your remote control and change a channel it always works.

So the powerful part of the control paradigm is that the supplier gets great control and is able to deliver a high-quality experience. On the other hand, the forces of freedom can give you chaos. It’s the Internet. You get error pages. You’re forced to your PC. But the benefit you get is rapid innovation. It’s chaotic, and there are errors but huge innovation. Think about blogs. No one ever heard of a blog five years ago. Now it’s more than a third of all words written on the Internet. It’s incredibly powerful. It’s an enormous amount of content getting created.

The rate of new media creation and innovation on the side of the forces of freedom is tremendous. I think the long term looks like, the Web is television and the remote control is the keyboard. And you are browsing the Web for all of your content. And you’ve got three channels going at once. That’s what it will look like in ten or twenty years. The market is growing so fast that there will be a lot of winners: the primary winners are those who deliver large Internet bandwidth: the telephone companies and cable companies who deliver high-speed Internet. Content creators will get more ways to get to customers.

Well, we mostly failed at it. We put a lot of effort in over five years. At one point, we started something called “Netflix friends,” and if you and a friend were both Netflix members you could give each other permission to see your movie ratings and what you’re watching. The good news is we saw early that there was a potential for something great. What we didn’t appreciate is that if you were sharing with a friend, you didn’t just want to share only your movies. You wanted to share your movies, your music, your ideas, your concepts. Social belonged to Facebook, not Netflix. We are an application on top of a social operating system. And we put all this work into being the system. So now we flipped to just making an easy connection through Facebook.

Target a specific niche. When there’s an ache, you want to be like aspirin, not vitamins. Aspirin solves a very particular problem someone has, whereas vitamins are a general “nice to have” market. Netflix was certainly aspirin.

You should stay flexible. We named the company Netflix, not DVDs by Mail, because we knew that eventually we would deliver movies directly over the Internet. DVDs will be around a long time, but for years we’ve been building for the day when they’re not.

Don’t underestimate the competition. We erroneously concluded that Blockbuster probably wasn’t going to launch a competitive effort when they hadn’t by 2003. Then, in 2004, they did. We thought, well, they won’t put much money behind it. Within four years, they invested more than $500 million against us.

And there are no shortcuts. Occasionally great wealth is created in a short amount of time, but it’s through a lot of luck in those situations. You just have to think of building an organization as a lot of work. It may or may not turn into great wealth. But it will be an exciting and fulfilling adventure.