Outside The Cable Box: The History of Netflix (Part 1)

Throughout its 22-year history, Netflix has transformed the entertainment industry. Netflix is one of the dot-com bubble’s biggest success stories. Much like other online startups in the late nineties such as Google and Amazon, Netflix would go on to change the way that the world receives entertainment. By disrupting the classic distribution chain that Hollywood once used to get content to consumers, they would set the example for how people would come to know, utilize and digest their home media/entertainment habits. So how did Netflix upend Hollywood and its home media distribution models? By revolutionizing how the modern world consumes content with out of the box thinking that was, and still is, ahead of its time.

Seed of Creation

Despite being an unequivocal powerhouse in our modern media-consuming market, Netflix came from humble beginnings. Reed Hastings and Marc Randolph co-founded Netflix in August of 1997 in Scotts Valley, CA. The two met while working together at Hastings’ previous company, Pure Atria, which was a debugging software company. After Hastings’ company absorbed a quality assurance startup that Randolph was involved with, he became head of marketing for Pure Atria, and the two began to work very closely together.

In 1997, Rational Software acquired Pure Atria for $700 million, which was the largest acquisition in Silicon Valley history at the time. More importantly, they were also part of a small group of employees that carpooled to work together from Santa Cruz, CA. As it turns out, the duo would often ride together, so they naturally struck up a friendship. While the merger was waiting to be approved, they would discuss what they were going to do next. These discussions would spark the seed of creation for what would eventually become Netflix.

Netflix Founders Marc Randolph (left) & Reed Hastings

Between Fact & Fiction

Depending on whom you talk to, the genesis of the idea behind Netflix is somewhere between fact and fiction. Originally, Hastings – whose story has changed throughout the years – first stated that he got the idea for Netflix after racking up $40 in late fees for a misplaced VHS copy of Apollo 13 from Blockbuster. This version of the story has gone on to become myth; only because they later admitted that this was an apocryphal tale to convey their business model early on efficiently. In later years, Hastings would also attribute the inspiration to Netflix’s business model came from a math problem that involved “Solving for volume as well as distance traveled.”

Randolph, on the other hand, tells a much different version of the story. During their many commutes together during the Pure Atria days Randolph and Hastings would have informal brainstorming sessions. Randolph also admired what Amazon was doing in the burgeoning e-commerce industry at the time and wanted to sell items on the Internet using a similar business model. They explored many different categories on their rides together, but they wanted to stay away from commoditized things like selling music or video. Eventually, however, they had the realization that you could take video rental and turn it into an e-commerce site.

Ahead of The Curve

There was one problem, though, home video technology at the time offered logistical challenges that were impossible to overcome. VHS tapes were too expensive to stock and ship cheaply, so the idea was rejected. In the spring of 1996, however, they read about a new technology that was being test-marketed in several major cities – Digital Versatile Disc (formerly Digital Video Disc), also known as DVD. Upon discovering this new video format, two things triggered the light bulb for Netflix. First, the new video format was likely to be commoditized. More importantly, it was the “form factor” that also made delivery feasible. That is, both the weight and size of the discs themselves.

One of the founding myths about Netflix that is actually true is how the duo tested out the feasibility of their idea. As the story goes, they went to a music store called Logos in Santa Cruz and bought a used CD. They proceeded to place the CD in a greeting card envelope with a first class stamp and dropped it in the mail. The next day, Hastings arrived to pick Randolph up with the envelope in his hand. In other words, the CD had arrived at Hastings’ house unbroken. Realizing that their idea might just work, after all, Randolph dove headfirst into working out the details that summer. While Randolph was doing most of the legwork in the early days, Hastings would check in on “How it was going with ideas, costs and how to overcome certain things.”

Making the Leap

One of the challenges to overcome was how to safely ship discs to customers with a single first-class stamp. They experimented with more than 200 different mailing packages, before designing one that included a stamped return envelope. Eventually, Randolph got to the point where the only way to continue was actually to commit to the idea. At that point, Hastings invested $2.5 million of his Pure Atria cash to get the startup off the ground. Whereas Randolph would oversee daily operations as the CEO early on, Hastings would serve as a consultant who would “dabble” in the business.

Despite all of the initial pieces finally falling into place, the original service bared minimal resemblance to the Netflix we know today. While they certainly saw the potential for taking advantage of the small size and weight of DVD, the fact that few video stores carried them yet also played into the initial strategy of Netflix. Essentially, they were betting on the fact that DVD’s would eventually replace VHS. Followed by other early online competitors such as Magic Disc and DVD Express, Netflix would become the first significant company to rent DVDs by mail. By the time that Netflix opened its virtual doors for business in April of 1998, it had 30 employees and 925 titles available for purchase – nearly the entire catalog of DVDs at the time.

Initially, they would offer a seven-day DVD rental for $4, plus $2 for shipping. The Cost would decrease with the rental of additional discs, and they could be kept longer for an additional fee. If customers wanted to purchase the DVD, they would keep it, and Netflix would charge the remaining retail balance to their credit card.

Bucking the Trend

Ironically, Netflix’s original business model also included late fees and traditional due dates. The initial reception to Netflix was overwhelming, which caused the website to shut down only days after it went live briefly. According to Randolph, the majority of their revenue came from selling DVDs in the first year. He described this as being a tough time for the business, mostly because they could sell DVDs but weren’t making a profit. Although Netflix had quickly struck deals to offer three free rentals to purchasers of new Toshiba and Sony DVD players, they didn’t see many repeat customers early on. Even though DVD players were still upward of $700 at the time, Netflix would eventually open its first distribution facility in San Jose, CA.

Seeing that rentals are where the real profits lie — along with successfully predicting competition in the growing DVD market from larger competitors like Wal-Mart and Amazon — Netflix decided to stop selling DVDs in December 1998. They would direct their business to Amazon, which had recently entered the market as predicted. In turn, Amazon would promote Netflix on its website for bowing out of the DVD sales race, which would boost business significantly. Even though they were taking a leap of faith in the new format, this would represent the first of many ingenious business moves for Netflix. Looking back, Randolph credited this shift to the notion that Netflix was about “finding the movies you love, which in fact has nothing to do with how you choose to receive them.”

Changing Of The Guard

By March 1999, Netflix had a cumulative inventory of more than 250,000 discs, with the company now buying 10,000 copies of some popular titles. Its staff had grown to 110 employees, with over 2,300 titles in stock. As the company continued to expand its reach, Hastings found himself devoting more and more time to the business. Although his interest in education reform remained a priority for the first eighteen months of Netflix’s operation, Hastings eventually found himself lured back to the company as a full-time employee.

In early 1999, Hastings would officially take over as CEO of Netflix, whereas Randolph would continue with the company as a member of the Board of Directors for the next five years. Years later, Randolph admitted that the return of Hastings was the best thing that could have happened to Netflix. “Well, you know, the company would never be where it is today if I had been running it. But then again, if I hadn’t been there in those first couple years, I don’t think it would be where it was either. So I’m extremely happy, extremely proud of how it worked out.”

By July of 1999, Hastings had announced an additional $30 million in new financing capital. The funds, which were procured from French investment firm Group Arnault, would be used to fund new brand-building endeavors in the coming years. This investment would allow Netflix to shift its business model entirely. In retrospect, it would not only put Netflix a step ahead of its competitors, but it would also give them the capital to establish their first significant innovation – An unlimited subscription plan for rentals. In September of that year, Netflix would once again roll the dice introducing the “Netflix marquee” program, something that would propel Netflix to the top of the online DVD rental space.

Marquee Attraction

This new program – which cost a meager $15.95 per month – would allow customers to pre-select up to 4 DVDs with no late fees or due dates. For Netflix to break even on the purchase of a disc for rental, they would need to generate 15-20 rentals for a given disc. To help circumvent this, Netflix also devised a queue system that would automatically send another pre-selected DVD once the others were returned. The queue would take it one step beyond what libraries do, except in a more efficient, automated manner. Think of it as an advanced reservation system for your movies — one that would lure customers toward new releases to maximize business.

Hastings commented that the new program was possible because of the “economics of scale” that the company had created for itself, because – around that time – they were processing around 10,000 orders each day. Even though Netflix had grown in popularity by the dawn of the new Millennium, they still reported $5 million in revenues, while operating on losses of $28.9 million. At the time, Netflix was spending heavily to lure customers to their growing website. As with many Internet startups around the turn of the century, they were betting that their service would become profitable after the brand became better established. Similarly, it would also set the stage for Netflix to utterly destroy the home video rental industry only a few years later. Little did they know, however, that this gamble would come to define the early days of the company entirely.

For the continued story of how Netflix came to dominate the streaming industry, make sure to check back for part two of our history on the company.

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