The Birth of Netflix and the Amazing Life of an Idea
“A charming first-person account of the early days of one of the most successful tech start-ups ever. An engaging read that will engross any would-be entrepreneur.”
-The Washington Post
By the age of 40, Marc Randolph had been fairly successful. After a stellar career in marketing, he had founded a startup that was acquired by Reed Hastings. Within six months, Hastings’s company was about to undergo a merger that made Randolph’s role as Vice President of Sales redundant. Randolph began toying with ideas for a new company based on e-commerce. The ideas ranged from personalized surfboards to custom-made baseball bats. Each idea would be discussed during the daily morning drive to work with Hastings, who would inevitably shoot it down as infeasible.
Eventually, they came upon the idea of video rentals through the internet. This was at a time when DVD was emerging as a smaller, slimmer medium that would replace bulky VHS tapes. A DVD could fit into a standard business envelope that costed only 32 cents to mail. If it arrived unscratched, renting DVDs through the mail could work. Randolph tested this by mailing Hastings a CD in an envelope, which was delivered unscratched the next day. Hastings and Randolph agreed to start a company that would allow customers to rent DVDs by mail. Hastings made a seed investment of $1.9 million, and Randolph decided to commit his time to build the company. Hastings would own 70% of the company and Randolph 30%.
A Santa Cruz Company
With seed capital in place, work to make the idea a reality began in earnest. It was time to build a team and find an office. Mitch Lowe, who’d spent decades in the rental business, knew studios and understood customer preferences, was brought in for his industry knowledge. Randolph was clear from the beginning that the office must be located in Santa Cruz and not in the heart of Silicon Valley. He wanted a slightly more laid-back environment and a clear work-life balance for his team. Most importantly, Randolph wanted work to be close to his home and family.
With seed funding in place, Randolph found a small office near his home. The space was furnished with cheap catering tables and old dining chairs from his house. Money was spent lavishly on technology – dozens of Dells and miles of ethernet cables. Around the same time, Randolph invested in buying a fifty-acre home in the hills for a million dollars. This created massive anxiety about the family’s financial state. The cure was to work even harder on making Netflix a reality.
For Randolph, one of the best things about leading a startup was the sheer number of problems he could work on. In the early stages, a company is small enough for everyone to wear multiple hats, but large enough so that one does not have to do something that didn’t suit their temperament or skillset. Netflix’s goal was to have the most complete DVD collection in the world with multiple copies of popular titles. This was not expensive inventory. It was inexpensive advertising. In the early days, there was no algorithm to decide how many copies of a title to buy. Mitch Lowe’s extensive industry knowledge was the algorithm that powered Netflix.
Netflix’s famous culture was not necessarily a product of premeditated planning. It arose organically from the values the team shared. Netflix was an opportunity for everyone to create the workspace they had dreamt of. Randolph’s approach essentially boiled down to this: hire great talent, give them tough problems, and the freedom to solve them. People are not motivated only by perks and salary; what they truly want from companies was to be treated like adults, have a mission they believed in, good problems to solve, and the freedom to solve them. They want to work with colleagues whose skills they respect. Years later, Netflix codified this as “Freedom and Responsibility”. People are hired because they were excellent at what they do so their judgment should be trusted. The role of the leader is to tell employees what the destination is, not how to get there. Each member would figure out their own way to reach the goal. Innovation does not come from top down diktats but emerges from empowering innovators by giving them the freedom to solve problems. Netflix calls this practice “being loosely coupled but tightly aligned”.
Randolph believes that people are more productive when their personal life is not taken over by their work. Even though the workweek was killing, there was flexibility. Randolph would start work at 7 a.m. and work till 6 p.m. After dinner with his family and putting the kids to bed, he would head back to work for a few more hours. Randolph always made it a point to leave the office at 5 p.m. sharp every Tuesday, no matter what, to spend the evening with his wife. He did not want to be a successful entrepreneur with a failed marriage. By November 1997, Netflix had an office, a semi-functional website, an inventory, mailer prototypes, and most importantly, a team with a great culture. The launch was planned for April 1998.
Netflix went live at 9 in the morning. The orders came flooding in, but so did thousands of unanticipated issues. Unable to handle the influx, both servers crashed within a few hours. Eight new servers were set up, but they too crashed in 45 minutes. The team even ran out of boxes and ink. At the end of the day, despite all the problems, they were a good sign to have.
Two months after launch, Netflix had 24 servers, and monthly revenue crossed $94,000. But only $1000 was in rental and the rest was from DVD sales. This was a problem because Netflix’s real competence laid in figuring out how to do DVD rentals online. To incentivize rentals and reach out to buyers of DVD players, Randolph finalized a deal with Toshiba wherein each customer who bought DVD players would get three free DVD rentals. It helped Netflix gain access to new DVD customers and enabled Toshiba to help customers find good content. A similar deal was later signed with industry giant Sony. Unfortunately, despite these excellent partnerships, rentals did not pick up.
Amazon made an offer to acquire Netflix but neither Hastings nor Randolph was ready to sell. They knew it was only a matter of time before Amazon began selling DVDs. They decided to focus entirely on the rental business, even though it was constituted less than 3% of Netflix’s revenue. Concentrating on one thing is imperative in a startup and Netflix couldn’t afford distractions.
The Clinton Testimonial
In 1998, America was gripped by President Bill Clinton’s affair with Monika Lewinsky. The House Judiciary Committee had announced that they would be releasing Clinton’s testimony video on broadcast networks. Randolph decided to cash in on this event by promising next-day delivery of the testimonial DVD for two cents. This move became a media sensation with coverage from the New York Times and the Wall Street Journal. Over 5,000 new customers were acquired by spending less than $5,000. However, comments on the site indicated that things had gone awry: some customers had been shipped pornography instead of the testimonial. It was a big bet and a big miss, for which Netflix came clean and apologized for, offering to take returns and send the Clinton testimonial back. Ironically, not a single DVD was returned.
Hastings takes the reins
Hastings expressed concerns regarding Randolph’s strategic judgment, hiring, and financial instincts. Hastings felt that these errors would become more costly as the company grows. He proposed that he takes over as CEO and Randolph takes the role of President. What Hastings said was harsh, but Randolph knew he was brutally honest. Randolph realized that he had two dreams: one of Netflix becoming successful, and another of him being the CEO. To do the best for the company, Randolph had to let Hastings take the reins. Randolph knew that their partnership would significantly improve the chances for Netflix’s success and create a company that they would both be proud of.
The early culture of Netflix was born from how Hastings and Randolph treated each other. Their principle of Radical Honesty meant raised voices and argumentations until the optimal solution was found. A culture of Freedom and Responsibility makes employees feel trusted and can give their utmost. Most companies hired people who lacked good judgment and spent effort defining everything from stationery to holidays through long processes just to protect themselves from such poor judgment. Netflix wanted to build a process for people with great judgment. Freedom and Responsibility, coupled with Radical Honesty, would be transformative in the long haul. But as the company grew, the question became how to scale it. This is where Patty McCord, the HR Head of Netflix, came in. She designed processes that encouraged freedom and fostered Netflix’s unique culture. Patty McCord pioneered concepts such unlimited vacation days and trust-based expense reimbursement, which went on to eventually redefine the field of HR itself.
Cracking DVD rentals
There was a larger change happening in Netflix. As the company grew, it was changing from being a team of passionate generalists to bringing in professional expertise. The decision to stop selling and focusing on rentals inflicted heavy financial loss on the company over months. If there were thousands of DVDs lying idly in a warehouse, the team thought, why not have them on customers’ shelves? A monthly subscription model would allow customers to rent a few discs at a time for as long as they wanted. They could return a disc and have the next one mailed to them. In a single stroke, this made Netflix a more accessible way to watch movies than driving down to the nearest Blockbuster store. People loved the idea of a one month trial, and 90% of those who clicked on the subscription ad provided credit card information. Sign up rates improved dramatically. Randolph says that there was no way they would have arrived at this rental model while starting Netflix. No one could predict which ideas were going to succeed and which weren’t. When no one knows anything for certain, one must have trust in oneself, test out the ideas, and be willing to fail. The subscription drove up site traffic by 300%.
Focus is the key weapon of an entrepreneur. The story of Netflix is one of unflinching willingness to abandon parts of the past to make way for the future. They called this the Canada Principle, which came from the idea that, while expanding into Canada could be a seemingly easy and profitable idea in the short term, could in fact be distracting to the business, dilute its focus, and endanger long term growth.
Netflix’s goal was to help people find the movies they love. But finding movies on an online store was difficult. Randolph and Hastings worked with the team to find a way to recommend movies based on the user’s viewing history. The problem was that there were endless factors that existed in establishing similarities between films. They initially established an algorithm that would make recommendations based on common renting patterns between users. Ultimately, they came up with a model by which users could review movies and the recommendation engine would make predictions on the basis of these qualitative reviews. The Cinematch algorithm was the beginning of Netflix’s legendary recommendation system.
The dot com bubble bursts
By September 2000, Netflix was worth $100 million, had 200,000 paying customers, and shipped over 800,000 discs a month. That was when the Dot Com bubble burst, and technology stocks collapsed. The one-month free trial subscription meant that Netflix was burning cash upfront and recovering it later in monthly installments. A rapid burn rate in an environment where funding was difficult to come by was far from an ideal situation. Hastings and Randolph offered to sell Netflix to Blockbuster for a price of $50 million but were turned down. There were no sources of funding and no selling their way out either. If the company had to survive, it had to do so on its own strength.
Netflix was on track to acquiring 500,000 users by the end of 2001. But it desperately needed a pathway to become profitable. There was a relentless focus on streamlining the service using the Canada Principle and improving efficiency. Despite these efforts, it became clear that they had to make deep budget cuts without hampering growth. Nearly 40% of the company lost their jobs. Though the layoffs were painful, the company was leaner, more focused, and more creative. Retaining only top-notch employees created a culture of competitive excellence. This is a pattern usually seen in startups. The focus and creativity of the initial team gets it off the ground, and growth brings more hiring. Then there is a contraction of team size, and the mission is carried forward on the shoulders of new specialists who replaced skilled generalists of the past. In May 2002, Netflix hit 1 million subscribers.
Randolph steps down
Considering his financial situation, Randolph wanted to sell some of his Netflix stock when the company went public. To do this and not create panic, he gave up his previous title and his seat on the board. Randolph downgraded his role to Executive Producer, and Hastings emerged as the face of the company. Netflix was listed on the NASDAQ in May 2002, and the share price was $16.19. The dream was a reality. Randolph’s life had changed forever.
In seven years, the company has managed to transform significantly. Randolph had gradually transitioned most of his role to other executives. He realized that what he truly loved to work on was leading small companies with smart people who tackled a huge challenge together. He could identify the core issues, inspire people to even take pay cuts, and make an idea a reality. While these were critical skills in a startup and he enjoyed the ride, Netflix was not like that anymore. It was time for Randolph to leave. Netflix rented out the Los Gatos theatre to give a thunderous farewell to its co-founder. True to Netflix’s tradition, it was a celebration.
Today, Netflix has over 150 million subscribers worldwide and has redefined how people consume entertainment. Randolph now mentors startups as a CEO coach.
According to Randolph, the only way to find out if an idea is good is to build it, test it, and sell it. As Nolan Bushnell, the co-founder of Atari, said, “Everyone who has taken a shower has had an idea. But it’s the people who get out of the shower, towel off, and do something about it that makes the difference”.