Season 3, Episode 8: Netflix (Part 1)

Transcript from https://podmenti.com/t/4282af5785c20bc3

Yep. And so funny, all the reviews of the iPad people were like
You can't hook up USB storage to the iPad. I'm like
I haven't used a USB thumb drive in like five years.
I don't care. My my biggest complaint is the lack of SCSI.
Yeah.
Yeah.
That's a teaser quote right there.

Welcome to Season 3, Episode 8 of Acquired, the show about technology, acquisitions, and IPOs.
I'm Ben Gilbert. I'm David Rosenthal.
And we are your hosts.
Today we are talking about a company that somehow
Somehow, David, we have not covered on the show yet.
Netflix.
And we're breaking this one into two parts.
Today we'll be covering the founding of the company up through the IPO and the waning years of their DVD business. And then next episode we'll pick up at the takeoff of streaming and original content.
So David I could not
believe this when diving in that the Netflix IPO was sixteen years ago and it was founded twenty one years ago.
Yeah.
Crazy.
All these fang companies, they're getting old.
I know. I mean I just I did not realize that it was a pre dot com bubble. In my head it was sort of like Facebook era, not Google era or Amazon era.
Well, this is why we have to do this as a two parter because uh you know, we when we first started researching this w we didn't think of it that way, but like there really are two different companies here. There's Netflix
Pre-streaming.
And Netflix post streaming.
Yeah.
We're gonna cover the pre streaming today.
Well listeners, we announced on the last episode that we had formally launched the Acquired Limited Partner program, and we've been totally floored by how many of you have joined our LP community and are listening to the bonus show. So if you'd like to join us and get an extra episode in between every normal acquired show, you can click the link in the show notes to join and support the show for five dollars a month.
Or go to Kimberlite.fm slash acquired. That's K A M B E R L I T E dot F M slash acquired.
On last week's bonus show episode, we talked about the elusive concept of product market fit and the practices, structures, and mindsets that successful companies do differently.
Before and after this stage.
All right listeners.
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And just tell'em that Ben and David sent you.
All right, David, you're ready to take us in with the acquisition, or I suppose the IPO history and facts. Uh well, there will be lots of acquisition offers back and forth as we go here, but uh. I which I didn't know until I started reading uh Dave and I both read this, uh there's a great book. By Gina Keating called Netflix. Netflixed.
Yeah.
This is really fun. I when we were discussing what episode to do, uh for this one, we were like, Okay, we're getting kinda towards the end of season three. We wanna do like a a big important splashy episode. Let's do one of the fang companies, Netflix.
I thought
You know, Netflix seems pretty straightforward. Like Reed Hastings, like very solid dude, you know, is for sure. But like very you know, it doesn't seem controversial. Like this seems pretty straightforward.
As always with these companies.
Once acquired shows up on the scene.
There is.
So much more to the story. There is. All right. Stop teasing us and go in. All right. All right. Okay. So as we mentioned up front, this is part one.
We're gonna cover Netflix from founding
Through about two thousand nine on this episode.
Part two next time, we're gonna go two thousand ten to the present.
But let's start with the founding.
So as I was alluding to, most people know or think they know the founding story of Netflix.
Nothing too controversial, it's the classic Silicon Valley startup story.
We go back to nineteen ninety seven.
A successful
Former enterprise software guy.
From Santa Cruz of all places, uh is fed up with movie rental late fees. Uh, these are the VHS days still.
And kinda sees the power of the coming wave of the internet, sees Amazon that's taking off, sees the potential to disrupt.
bricks and mortar retail and starts what would become Netflix and and becomes
himself, you know, paragon of Silicon Valley, statesman
Of course I'm talking about
Mark Randolph.
Not
Read Hastings.
Uh this is a true statement, the illustrious CEO of Netflix.
The illustrious CEO of Netflix. I I texted Ben when we started researching this and and reading Netflix. The parallels to Tesla here are like unreal. It's pretty awesome.
Yeah, so Mark Randolph, the the reason that is true is he was the CEO of Netflix for the first year while Reed Hastings was finishing up uh graduate school at Stanford.
Yes. But really he was the founder and and CEO of Netflix.
Think it was closer to two, but I'll have to go through my notes here as we as we dig through.
Let me give you two other wild Mark Randolph facts from his background.
One is that he helped to found Macworld magazine.
Yes.
Love that.
And two is he is currently on the board of Chubby's shorts. Yes.
Yes. And um Looker, I believe. The analytics tool.
And and liquor actually came out of Netflix, I think, which would make sense. Okay. So here is the official story. If you listen to Reed Hastings, if you listen to Netflix, the the official founding story
the lore. We're gonna give you that, then we're gonna tell you the true story. So
Official story Read Hastings.
He has been a successful technology entrepreneur in the enterprise space. And he has an epiphany for what would become Netflix. He's returning an overdue movie to his local video store. Now originally the version of this story that he would tell is he was returning it to a blockbuster.
That gets changed not to a Blockbuster after a lawsuit between Blockbuster and Netflix.
And you know how your founding story can just change.
Yes, just change. Whether it was true or not. Uh we've seen this many times. So he's he's returned the movie to the local video store.
And he's so fed up, he comes up with this magical subscription model alternative when he's on a treadmill at the gym. This isn't just like Lord, like I'm actually here, I'm gonna quote from Reed Hastings saying in print to Fortune magazine in two thousand nine.
The genesis of Netflix came in 1997 when I got this late fee about$40 for Apollo 13.
Remember Apollo thirteen? So good. Great film. Uh I remember the fee because I was embarrassed about it. That was back in the VHS days, and it got me thinking that there's a big market out there.
I didn't know about DVDs and then a friend of mine told me they were coming.
And I ran out to Tower Records in Santa Cruz, California, and mailed CDs to myself.
Just a disc in an envelope. It was a long twenty four hours until the mail arrived back at my house
I ripped them open and they were all in great shape. That was the big excitement point.
Another another fun element on this story is the reason that he talks about being on the treadmill is because uh he
He also talks about how the gym memberships you pay monthly, whether you sort of use it or not, and he was like, Oh, I can totally apply that. It was like the very same day that I was upset about my late fee for Apollo thirteen, I happened to be going to the gym later thinking about their business model. And it's like this completely convoluted apocryphal story invented
Purely to explain like what is the Netflix business model and what was the opportunity to be found.
You know, we we've talked about this a bunch on the show, but like I actually don't think there's anything wrong with this.'Cause especially in the
early days of a company, you need to communicate your value prop and stories are how you do that. So yeah um
You know, just something like this happened, it just wasn't as clean. Yeah. So okay.
What's the real story?
One note as we dive in here, it is helpful to be familiar with Bay Area geography when discussing uh Netflix. So for those of you who are, you will intimately understand this. For those of you who aren't, we will try and guide you along the way.
So it was nineteen ninety seven.
Reed Hastings was involved.
But as also, of course, was Mark Randolph.
And they knew each other because they worked together at a company called Pure Atria, uh formerly Pure Software and
In Sunnyvale, California. Which merged with Atria.
Which merged with H yeah. So what was what was this company? Uh it was a publicly traded company.
It made bug detection software for developers.
Tools company Ben. We we should also say this was Reed Hastings. He founded this company also. He founded Pure Software.
And for Reed, this was his second job. He did a a job for three years and then decided, I'm gonna start a company. David, I don't know if you're are you gonna touch on his his background before starting Pure?
Not really. Not really, so go for it.
Alright, so
Uh Reed Hastings is like an unbelievable human being. So he went to school to join the Marines and ended up dropping out instead to completely flip tracks and join the Peace Corps.
And after he finished the Peace Corps, went and took his first job, then his his second job was um starting pure. And in between he did a master's in C S at Stanford. I think he went to Bowden undergrad on the East Coast, I think. Um but yeah, that's it that's how he got out to the valley.
So
He's running pure.
It's going well. It was sort of predicated on a a simple notion that he had around building a better debugger. He's starting to amass a large team, you know, they're they're taking all this money, they're getting ready to go public. He tells the board, Hey, I wanna not be CEO of this company. I I've never been a manager, you know, it's kind of like
I think for the benefit of myself and all the other shareholders, we really should get a CEO.
The board says no, you should remain CEO, and he ends up basically learning on the fly and then you know successfully manages to both IPO this company and then merge it with Atria. Such like the opposite of what was usually what boards were usually in the day and age, which was firing CEOs as soon as they humanly could.
Yeah.
Okay.
So
As been alluded to.
Pure Atria at this point, it's publicly traded. It's basically a roll up. They acquired Atria. They acquired a bunch of companies that are all in the space. They're rolling up and consolidating.
Randolph, Mark Randolph, had been at one of the comp small companies that Pureatria had acquired. Um and after the acquisition, he Reed uh kind of takes a liking to him and he gets promoted. He becomes head of marketing for the whole combined company. So they're working pretty closely together.
So it's 1997. One final piece of this roll-up is happening, though, and that's the biggest piece, which is there's a huge merger that's about to happen between Pure and Rational Software, um, which is the biggest competitor in the space. They've just announced they're gonna merge public to public merger. It is actually going to be the largest merger in Silicon Valley history.
at that point in nineteen ninety seven, valued at just under a billion dollars. Yeah. Cute. Cute. Just under a billion dollars. Um
And Reed Hastings is finally going to get his wish. He's going to be fired as CEO. Not fired, but he's he's gonna be redundant. He's not gonna stay with the company, uh, neither is Randolph. And it's interesting to note here, uh Hastings is
really bummed about what has happened to the culture.
And it's important to think about as we talk about Netflix later. Hastings says that Pure, like uh a lot of these other companies, went from being a heat filled everybody wants to be here place to a dronish and I'm quoting here, when does the day end sausage factory? And he says, We got more bureaucratic as we grew, um, and and his
thinking at that time is whatever I do in the future, when the next thing I have to start, we have to think of systems so that we don't end up like that. Yeah. And that will
Come back into play.
Reed is about to become hugely wealthy. Like he's still very young, hugely wealthy, and and his plan is to basically ride off into the sunset. He's reapplied to Stanford, um, this time to do the graduate program in education.
Which is a fantastic program, by the way. A lot of people do G S B and uh the education masters jointly. Reed's gonna go do
this one year grad program in education.
With the intention of he's going to become an education focused philanthropist for the rest of his life. Randolph, though, he he's not so, you know, not about to become so wealthy. He he has to keep working. So he decides what he wants to do is he wants to start a company. And he really admires Amazon, um, which is public at this point, been around for a few years, and he thinks
that there's a really good opportunity to do just like Bezos was thinking, he was looking at all the categories he could attack. He chose books. Randolph thinks, well I can just choose another category and run the same Amazon playbook.
And it just so happens that in addition to working together, Reed and Mark
Both live in Santa Cruz.
So this is, I said, Bay Area geography is gonna become important. Santa Cruz is a sleepy little university slash beach slash surfer town over the Santa Cruz mountains, which separate
Uh Silicon Valley.
Uh the valley is on the inland side of the mountains from the
Pacific Ocean, Santa Cruz is on the ocean side. The mountains are awesome and it's beautiful, but like they're very high and it is very remote. Like if you live in Santa Cruz, you do not live in Silicon Valley. And it takes about an hour to commute back and forth, but just like the whole vibe is like beach town, surfer town, not not, you know, everything we think of is Silicon Valley.
So as a result, Reed and Mark are often carpooling.
together back and forth between Sunnyvale, where Pierre is based, and Santa Cruz. And so Randolph just starts like spitballing ideas with Reed during their car rides. He's like, what about this category? What about that category? What about that category? And he's convinced he wants to do this, so he starts a shell company. He calls it Kibble Inc because
The idea is get the dogs to eat the dog food, so kibble, ink, dog food. Yeah.
Anyway. Um
He starts the shell company, their spitballing stuff. He he starts thinking about as Ben alluded to, he'd worked at Macworld. He had also worked in the direct mail industry. That's how he got into marketing. He's presumably we don't know this for a fact, but because of that, very familiar with the
AOL, Prodigy, CompuServe.
customer acquisition techniques that I think we've referred to in the past of uh
Just mailing out tons and tons of C D to potential customers. I mean how many
AOL C D's did you have mailed to your house back in the day. Oh my gosh. And the best thing was every time you'd go to like a movie theater or something, there'd just be another box full of them at the desk. The whole country in like, you know.
When would this been, like ninety five to ninety nine? It was just saturated with
A O L coasters. Well the the important thing that I want to say about Arandolph here is hit basically his background before Puratria, he's a publishing guy. He knows the publishing industry inside and out, and kinda stacked on top of that, he's a
data and analytics guy, which didn't really exist in meaningful form. You know, there was no digital data and analytics then, so he was frequently tasked with things like surveying audience and trying to understand who are our readers. His philosophy as he's spitballing a lot of these different ideas here is thinking about
How can we automatically, probably through the user interface of some product, build a data and analytics suite?
And how can we build sort of intelligence into the UI to automatically do things that make the experience of consuming better? It's funny to see all these different threads that become massive pillars of Netflix today that are in sort of the backgrounds of these founders.
Like you said, those become the pillars of
Netflix from
Mark Randolph's history and background to Netflix today. So
Inspired by this, he hears about this coming new video format called DVD. It's just just getting launched. It's in the the movie studios and electronics manufacturers are just rolling it out. It's being launched in a few test markets.
Um, and of course D V Ds come on.
Optical discs that are the same.
form factor as a CD. And so Randolph's like, Oh
Well, maybe we can uh mail these things. Um so they do go he does go to um a local record store, not Tower Records in Santa Cruz, uh buys a CD, goes to a gift card, buys a um
very like large like birthday card and stuffs the CD in it and mails it to Reed Hastings house.
The next day or two when they're meeting to commute together, Reed's got the mail. He's got the envelope and he's like, It came.
It's fine. Dude, this this blew my mind when I read this story.
Today when we think about the old Netflix, we're like, oh man, it started in that era of DVDs as if it was so long ago. It started before DVDs and they had to proxy like, can we mail DVDs by mailing a CD? Because neither of them had ever touched a DVD before when they had this idea.
I mean, talk about like being on the very tip of a wave and then uh and then sort of riding it the whole way. Like they were betting that D V D was going to succeed and that'cause th they evaluated would this work with tapes and they were like, Nope, shipping costs are too high.
Shipping costs are too high and
Just logistically, like you gotta store'em and cattle like
The CDs are tiny.
Although not as tiny as bits. So Netflix.
It's it's boring. It's off to the races. So so what happens? Reed is like great
I'm going off to Stanford, um, but I've got all this money. I I think I'm gonna dabble in angel investing. Um, I'll fund this company. So uh just like Elon did with Tesla, a reed leads the first round of funding in Kibble Inc.
uh which uh in a little bit becomes Netflix. Reed invests two million dollars. Randolph becomes the CEO, Reed is just an investor and on the board. They recruit the initial team, they set up their first office in Scots Valley, which is still on the Santa Cruz side of the mountains, just a little bit north of the town of Santa Cruz.
And the idea is, yep, we're running the Amazon playbook, except instead of attacking
Borders and Barnes and Noble, we are attacking Blockbuster.
It turns out that
Unsurprisingly, it's actually a pretty good idea. So the home video industry at this point is now bigger than box office for uh for film and television. Um, or I guess mostly film at this point. It's enormous.
And the rental segment, so there's both sales and rental uh of home video. The rental segment is completely dominated by Blockbuster. There's Hollywood video and a few others, but like Blockbuster is the the eight hundred pound gorilla. I want to quote the S one here because for for entrepreneurs out there who are listening, the moral of this story is
You never get to stop justifying your market size to investors. It's gonna be in your seed pitch deck, it's gonna be in your A pitch deck. And the second paragraph of the S one and when Netflix goes public, the first paragraph describes what they do. The second paragraph is
In two thousand one, domestic consumers spent more than thirty two billion dollars on in home filmed entertainment, representing approximately eighty percent of filmed entertain blah blah blah, goes on to talk about exactly what David just said, that the the largest portion is rental. I was reading the S one and I just chuckling that like
The story at any stage is always the same. What do you do? Why could it be huge? Why is it important? Then how are you differentiated? Yeah, like it just it never ends.
The more things change.
And where they stay the same. Quick aside, uh, because I think there's an important point here, this whole business of movie rentals.
is i in the first iteration of Netflix's business and and the blockbuster business is enabled by a Supreme Court ruling around copyright law of what's called the first sale doctrine. Um and it basically says that once you buy a copy of any copyrighted work, whether that's a book or a movie or whatever,
You can then do whatever you want with it. You can resell it, you can rent it out, like it's yours, you have then cleared the copyright. That was established well before any of these businesses, but
The important point in here is that like regulatory issues and and lobbying and getting regulatory issues favorable to your business are very, very important. I feel like
Silicon Valley n now knows that, but for a long time forgot that. And like this whole industry is enabled by a Supreme Court ruling. And and fortunately, in a very sort of Bezos way, where he he Bezos always credits the uh infrastructure that was laid before him that allowed the company to exist, the internet, um UPS, et cetera. Like
you know, this wouldn't have been possible if w what they had to do was go and lobby and get laws changed at the outset. Infrastructure had been been laid for them.
Go vote. It's important. Hopefully you already voted in this these elections.
Yeah.
I assumed they had to pay some form of royalty back to the content holder every time they r rented it. I mean the then Blockbuster, like before Netflix comes along and you're just fat and happy Blockbuster, that's kind of an amazing business. I mean you buy this little store, it's not that big of square footage. You pay fifteen to eighteen dollars or whatever for a movie.
And then you rent it out for what, like three three dollars and you run it
fifty times or something. It's a awesome business. It's the same business as scooters today. You know, you buy a scooter three hundred bucks, you rent it for couple bucks per ride, and you do thousands of rides and
That's good business.
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Okay, so they're getting started. Randolph goes to a conference in Las Vegas, the Software Video Conference. He meets a guy named Mitch Lowe, who's gonna come back into the story later. Mitch owns a 10-store video rental chain, small rental chain in Marin County, just north of San Francisco, again, Bay Area geography.
This is about as far on the opposite end of the Bay Area as you can get from Santa Cruz. Uh we're talking like two and a half hour drive with no traffic. Mitch is entrepreneurial. He owns these video rental stores, but he's also working on a a software tool, a CRM tool for
video rental stores. And Randolph's like, Oh man, you are like the industry expert. Like I need you to come in and like join the team. He eventually persuades him to do so. I assume Mitch then moves from Marin to Santa Cruz, because you cannot do that commute every day. But he joins as the video acquisition chief. So he's now going to be in charge of like
inventory and stocking and like what what DVDs Netflix is gonna buy. And so it's kind of just like Stitch Fix like that we saw there, like it getting that early industry DNA on the team like really has a big impact.
Together they and and they'd hired a couple people from Pure, a couple folks that they'd worked with in the marketing department there. They all set on the settle on Netflix as the name. And uh Ben Ben texted me the original logo. We're gonna have to tweet this and link to it in the show notes. Let's just say you don't want enterprise marketing people designing your consumer
product uh branding and and logo.
I think I think show notes can be a full HTML, so we'll just try and embed this image in the show notes if you swipe over or tap over to it. It is awesome. And the best thing is it was used to be. It was ninety seven to two thousand and
You know, Netflix on their next Rev kind of nailed it and is basically the same logo they use today, except with a little bit of a nice brand refresh, but like the the first one is
It
It's got this little like swooshy thing and
It's very late nineties. Yep. So it it's purple. It's bad. It's bad. Um
Netflix.
So what did they do? This is this is brilliant. And I think this is driven by by Mitch Lowe. DVDs are just getting launched. Like they're like
Most people don't have it. Player machines don't exist out there. How do they do like get their initial customers, do initial customer feedback? They they borrow a page, future page from Xiaomi. They go online into product discussion forums of enthusiasts for like
movie technology and like D V D product forums and they just start talking about Netflix there and like people are like six hundred bucks. Like getting a D V D player was like uh ooh, I'm buying it's like over a thousand bucks at this point.
In nineteen ninety seven dollars.
So like the people who are buying these things are super techie, super early adopters, like the perfect market to adopt Netflix and and give, you know, feedback here.
Isn't it six forty by four eighty? Like it's there's not a lot of that. Like yeah, uh I think that I think it might even be less. Like, you know, there's it's for show research here, we didn't even go back and watch D V D's. Like I don't I don't have a D V Drive anywhere. I don't know if you do. Like
No, I sold my old Xbox and I have no I actually have no means to play any discs. You know me neither.
Yeah.
Well, uh wait for stay tuned for part two. Um
So they officially launched
The ca the product in April nineteen ninety eight. Now remember they've been building all this momentum and uh you know early customer lists from these product forums.
And it's just like
They nail it. Like the market is still tiny, but like
Talk about product market fit on day one. The servers crash. There's tons of demand. You could buy DVDs from them, right?
Yes, you could both buy and rent. Yeah. Yeah.
I mean the magic that they came up with was the business model of rather than paying per D V D, you just
pay a certain amount and then it you can either keep two or keep three depending on what what plan you opt into. But I didn't realize when they started you could also just order DVDs from them and pay for them and keep them. Yeah. Totally. Uh well th that part of the business is going to come up again in in in one sec. The other perfect part of the timing here is like
The consumer electronics manufacturers were so powerful this time. We're talking Sony, Toshiba, Panasonic, like all these Japanese and some US, I forget which ones are US companies anyway. Like
These guys are dominant. They're so and and they know that DVD machines, like that's their next drug that they're gonna sell US consumers. Um, so they're pushing it hard, Best Buy's pushing it hard, Circuit City's pushing it hard. Netflix goes and they do deals with these consumer electronics manufacturers to get Netflix promo coupons.
Inserted into the boxes with DVD players. Like talk about an awesome distribution hack. Like it doesn't get it any better than that. Uh and this was a big part of their customer acquisition for many, many years. And it works like uh amazingly.
the the only downside is they're giving away a free month of Netflix uh as the promotion. Um that ends up coming back to bite them in terms of that cost them a lot of money, um, which we'll see in a sec.
Blockbuster, while all this is going on, they're initially like, Oh DVDs. That's like nobody's gonna use that. Like, you know, we're just gonna stick with VHS. It feels short sighted to me.
in a different way than we normally rip on big companies that get disrupted. Like if you were to tell Blockbuster at that time streaming video on the internet will be the thing that ends you. Like
It's not that surprising for me
that they would scoff at that. And like it just didn't feel like it just felt like that was too far away and would people actually do that? And but like
Just switching the size of the box.
And like switching to a thing that plays videos better and like
Come on, all electronics come down over time. How c how could they not believe that this was gonna be
a big change for their business. Well, okay. So let's be
really fair to Blockbuster here. So I went into research here thinking Blockbuster, oh my God, these guys are m idiots. Like this is like, you know, classic case of corporate hubris getting disrupted. Not the case at all. Blockbuster management until the very end, as we'll see, is actually super competent and like really good.
And the reason here that they didn't go into the market as fast as Netflix is there was a format war. So DVD and Divics were battling it out against one another, and it wasn't clear in the beginning who was gonna win. Oh, I forgot about DivX. Yeah, Divix. Um
That's like way lesser known than even like Betamax or HD DVD or any of these alternatives. It was the betamax of of the the optical disc era. So Blockbuster was kinda waiting on the sidelines to see what would happen before they made the big bet and threw their weight behind it. Uh Netflix bet the company on DVD over DivX.
I don't know why. Maybe they just were like, Oh, D V D, we'll go with that. Um
But fortunately it worked. Um so that's Divix ended up becoming like a digital like a not stream, but like file it was like a file. It was like a file encoder format and I used to have like a Divix player.
on my Mac that I could like play Divx files if I was downloading them from uh the back of a truck somewhere and
Yeah.
Oh, the early two thousands. So
Blockbuster isn't in the DVD game yet. Netflix is the only game in town. They've got promos in all the boxes with the players that are that are shipping.
The first four months after launch, they do twenty thousand rentals. They're already at a million dollar revenue run rate. Like that's super impressive. Even today, like startup you launch here at a million dollar revenue run rate.
Four months in, like
Super impressive. And super capital efficient considering they were buying all these DVDs. Like I I can't remember what did they they had only raised the money from Reed to date, right? Yeah, only the two million dollars. Well capital efficient
Yeah, yes. Yes, yes. But with all this growth, like they are just burning huge like like they're they're they're really in a rock and hour place because i they have to buy the DVDs. That's capital efficient. But the operations, this is why giving away those free rentals, the free month of rentals, which is gonna end up being a couple, like they have to
package these things in mailers, they have to ship them, they have to do all the labor to do that. They have to do the customer support. It gets really expensive to operate this. And the more you grow, the more expensive it gets. They realize that the the Netflix actually had this perverse
aspect of their business model in the DVD streaming era, that their very best customers who use them the most cost them the most money. So they uh realized pretty early on before the streaming era, just before oh yeah, before the in the DVD era. Because if you're constantly rotating discs in and out, you're costing Netflix a lot of money and operations to do that.
So they
they figure out that they need to funnel customers to really obscure niches of like back catalog titles because those don't turn over as much. Like I might really love some like random thing. It's unlikely somebody else does. So I'm gonna rent that, keep it for a long time, and then I don't have other demand for that.
uh that unit.
So that's how they start working on the recommendation algorithm and the personalization. As a result, it's not big new releases that drive Netflix in the early days. It's the back catalog. So Bollywood movies become huge. And this is funny. Um softcore pornography becomes huge.
As with all video formats, uh the uh
aphorism that pornography drives innovation. Um, also true here. It's gonna come back in a sec. So they raise a series A. They raise a six million dollar series A from IVP uh in August nineteen ninety eight to finance all of this. Reed is still finishing up at Stanford.
He's just the investor, the angel investor, he's just on the board. He's not super involved. Uh once he finishes his master's, he gets into, you know, education philanthropy as he wanted to. He also starts this thing called Technet.
Um, which is a
lobbying group for the technology industry. It's still the largest tech industry lobbying group. I didn't realize Reed Hastings started it like pretty cool. Um so he starts that he's running that.
January nineteen ninety nine, a couple things happen. One, there's some uh Reed is very liberal in his politics and other people in tech, at least at that point time and still weren't, and they were like, You're running this lobbying group, you're very liberal, like I'm conservative, like this should be more bipartisan, so
Reed ends up leaving Technet. He wants to get back into the entrepreneurial game. He's like, Oh, Netflix, my angel investment is kind of working. I'm gonna go spend some more time there. He basically just shows up and announces, like, okay, now I'm gonna be co-CEO with Randolph here. And uh Randolph is apparently not super happy about this, but like
You know, the company's growing, so
And Reed is great, so like everybody kinda gets along.
And they initially divvied up that Randolph's gonna be in charge of marketing and content acquisition, and Reed is gonna be in charge of engineering and and ops. This is where Reed really starts building like a world class technical team, technical and ops team at at Netflix. I think this is the time when they actually name their algorithm the Cinematch.
And they start having a company wide metric around uh what percentage of the long tail of the DVDs are we actually successfully managing to uh get people to use their use one of their slots on.
Yep.
Yep.
Obviously that we'll get into the Netflix.
the challenge way later, but um this is really when it starts to become really in a lot of ways pioneering modern data science and and data engineering.
Yep.
And remember, they're still in Santa Cruz in Scots Valley at this point. So Reed shows up and he's like, Okay, a few things need to change around here. So one, even though they just raised this series A, they're still burning cash so fast because they're growing so quickly. They realize they need to fundraise
again really quickly or like do something or they're gonna go bankrupt. So the first thing that the board and read and mark think is like
Uh we should maybe we should just sell the company, like do a quick flip here.
They and who would be the natural acquirer
None other.
Then the inspiration for the company.
Jeff Bezos.
So the two of them fly up to Seattle. They meet with Bezos. This is uh this is nineteen ninety-eight still, I believe. Bezos is like, Oh, you know, this is interesting. Okay, and Amazon is public, they've made some acquisitions at this point. Um Bezos is like, I'll give you twelve million dollars to buy the company.
Um, which I assume must have been right around the post money for uh or maybe even less than the post of the raise that they just did. And Netflix is like, come on, like, no. We're not gonna sell the company, but how about we do a a cross promotion deal with you guys where we've got this business where we're selling DVDs.
Um, we're realizing that that's not super core to to our subscription model. Um how about we
give you that. So whenever anybody on any Netflix customers want to buy D V D, we'll just kick them over to Amazon to buy D V D. Um and in exchange I think this happened to me once.
Oh really? I'm now like recalling it was in that era of Amazon doing these weird partnerships like when I was Toys Orbs and Target was like Yeah.
Yeah.
Oh man, it's crazy imagining Amazon today doing some gigantic co branded corner of their their store like that. Seriously, especially given
What we'll see in part two with Amazon and and video. So in return, Amazon is gonna advertise Netflix on the homepage. Remember, this is the era of portals and now the most valuable real estate in technology.
Crazy. So that happens. On the back of that, they start fundraising, and as they go out to fundraise, Reed is like, okay, like I'm the successful past entrepreneur here. I'm gonna take over as the only CEO. I'm gonna do this.
Yeah.
Uh he also he's like
And we gotta move out of Santa Cruz. We're gonna move to Silicon Valley. So they compromise. They move to Silicon Valley, technically, but they move to Los Gatos, which is like
As far south as you can possibly get in Silicon Valley. So probably another
Thirty plus minutes south of Palo Alto in Mountain View, I would say.
And Netflix is still there today and lots of people
um, especially as the company's grown, now live in San Francisco and work in Los Gatos and spend
Two hours a day on on one oh one commuting. Incredible.
This is a good time. So it's a pretty special company to work for. When you think about why do people do this two hour commute.
I'm actually not sure when this
notorious deck uh started in its first revision, but the Netflix culture is extremely unique. In the early days, and I don't know if the early days was right around this time or even earlier, Hastings decided that he needed to be able to communicate to new hires all the ways that they were very different and very opinionated in a culture.
And he wanted to preserve this in a way that would scale because it it didn't at his last company. To illustrate the point, there's two interesting things that I'll mention from Netflix's culture. One of which is that uh Hastings doesn't ever refer to it as a family. It's not welcome to the family. The uh more appropriate analogy is a sports team.
that we don't have unconditional love for each other. We have conditional love. We have really high standards and a really high performing team and to the degree that in a family you can sort of love someone even if they're not uh an amazing employee on a team you don't.
The second tidbit is that
out of respect for everyone else on the team.
they hold every seat to a really high regard and so
you you will be let go from the company
if you are not performing really well. And it's not because they're punishing you for that or anything. It's out of respect to everyone else who is still at the company because they deserve to work with an eight player. And they say they take the burden on this and say we're extremely generous with Severance, but
uh were extremely opinionated that er, you know, you need to be an extremely high performer to have that seat. Otherwise you need to make it available for someone else out of fairness. I've always thought like
the way that all this is sort of like phrased and they came up with this is so
Both opinionated and thoughtful, and every little detail considered. Now uh Hastings has released the deck on Slide Share, and I think it might be like the number one viewed uh deck on Slide Share. Yeah, yeah. Yeah.
Yeah. And so like it was this internal thing that they evolved over and over and over and then finally decided we should make this available for public consumption'cause it's a gr a great recruiting tool. I mean, for the right set of people, like that's why they did it. Yeah. Yeah. Yeah. So one of the things that makes them different.
You see
read's personal history and and
shaping reflected in this culture. Like as all companies, right, are like like my partner Riley at Wave is uh he always says like
Company cultures are like reflective
Pure reflections of the
founder, you know, personalities. And uh, you know, Rita's a guy who was in ROTC who was gonna join the Marines and then instead did the Peace Corps and then, you know, went to Silicon Valley and became an engine and then a CEO and then a philanthropist. And like it's just all like these this dichotomy like baked in there.
Very cool.
In addition to all of those things, he is also a fundraising machine. Remember, he has orchestrated the largest merger in Silicon Valley history at this point. So basically every VC, and this is before the the dot com crash, they're like
Oh, Reed Hastings, you're raising like how much money can I give you? Um He raises within a few months raises a hundred million dollars. Or or rephrased uh from our last uh LP bonus show, how large of a percentage ownership can I have in your company? Yes, exactly. And I don't care what the tech size is.
Uh right.
A hundred million dollars mostly from T C V uh and we'll see T C V ends up being a enormous shareholder in Netflix, um and IPO and several other firms. Uh one of the first hires he makes after
becoming full CO of the company.
is acquired superhero who has showed up in uh in uh at least one other episode probably many more.
Barry McCarthy, who he hires as CFO of Netflix, and Barry becomes
critical to Netflix's success. Um and uh
Then does his short detour at Clinkle before going to Spotify.
Yeah, fast forward through that or uh DVD skip through that. So Barry's fame from folks who have listened to the uh the Spotify episode is that he's the guy who sort of uh
conceived of and then executed the plan for the direct listing where where Spotify did not actually issue new shares at IPO, they had a direct listing.
Huge, huge hire.
As well as several other folks, they hire Tom Dillon from Seagate to run ops for the company. Remember, ops is super important here. And then together this lead new leadership team, like they all kind of figure out like
uh sort of similar to Amazon and Prime, that delivery speed for rentals, movie rentals when DVD rentals when you order them is huge. And that the faster they can get
From you clicking a rental.
online on Netflix to getting the DVD in your mailbox.
That drives customer loyalty, that drives retention, but most importantly, that drives word of mouth uh an organic
distribution. Like when you
click rent magical experience. And you get remember, this is yeah, nineteen ninety eight, ninety nine, you get that DVD in your mailbox the next day, you're gonna tell all your friends.
It's funny, like, how archaic it feels now, because now I'm like pff, how could it not be i you know, actually instant. But I I am remembering
I'm trying to think what year it was. Probably two thousand it was the summer of two thousand eight, because I was doing my internship in uh in North Carolina for Cisco. And my roommates and I did a Netflix plan for our apartment, uh, because none of us were twenty-one yet. And so we were like
w what do we do every day after work? And so we just got a really fat Netflix plan. And like it was pretty amazing that like you uh we'd hear about a movie from a friend over the weekend, we'd like click the button and then we were watching it Tuesday night and sometimes even Monday night. And it's it's like
It's it's funny to describe that as a magical experience, but it totally was.
And this is all thanks to
Dylan and McCarthy and and and Reed and and and the rest of the company of the company, of course, but they figure this out and they realize that this is the key
one of the key levers to their business. So they start building distribution centers, not just like randomly like, oh, we're gonna build them in big cities in geographical density. They start like they get really analytical about it. Like where's our customer base? Where's it growing? Where are our word of mouth hot spots? Let's build distribution centers close to them.
and get these D V Ds to them as fast as possible and grow demand.
kind of organically this way, also helps them better manage inventory, uh, everything. And then of course this leads to the recommendation algorithm becoming super, super important. Did you ever m manage your Netflix queue? I I'm like remembering old features now that were like critically important to the service. Did you were you were you a subscriber back then?
No, I subscribe way late. I'm not I don't watch a ton of movies, so uh it was I was not in the target market.
I remember being obsessed and actually comparing my cue with friends. It was two things that were important to like compare with friends. One was like all my ratings. I'm like a completionist. When Twitter was not algorithmic, I try to read every tweet. I think I did between like 2009 and like 2017.
And so like I tried to like rate every movie I'd ever seen and find it on Netflix and rate it. And like though I had a group of friends that totally prided themselves on doing that and being very opinionated about each of these movies. And the other thing that I definitely remember is I built up this huge cue that I was constantly adjusting of like which movies were gonna be sent to me when.
and like how much did I want to prioritize moving something through the queue. And I thought, I mean, both of those systems were just genius because they were I know Netflix wasn't measuring engagement, but engagement ended up being a proxy for uh how long am I going to stay a customer.
And like both of those things like lit up my brain in all the right ways of oh, I have to go and update this piece of data on Netflix. And lay the groundwork for
Netflix today and streaming. Um
One real quick funny aside, I mentioned um pornography being uh a big part of Netflix in the early days. Reed uh in two thousand, he gets appointed to the California Board of Education
Yeah, he's like, um, we need to get out of this pornography thing. So uh let's just uh let's just uh that that that never happened. So another thing you will never find in Netflix history, but did drive a bunch of their growth in the early days. Okay. It's 2000. Growth is great, everybody's high flying, high fiving, they got a A team, you know, built.
at the company they filed to go public. McCarthy's gonna take them public to
They have 120,000 subscribers, they're shipping 800,000 DVDs a month. Everything is great.
But then the dot com crash happens before uh before they can actually get out and get public. They postpone the IPO.
But again, they're still growing. And again, as they grow, they're burning all this capital so much so that they've burned through the hundred million dollars that they've raised. Fortunately, the existing investors were so excited before the IPO, they wanted to buy in and get
More of the company and get a pop, they invest another about$50 million before the IPO and before the crash. Turns out to be super necessary capital.
But the crash happens and like they're like, I don't think we can survive.
Once again they try and offload the company and sell it, this time not to Amazon, they go to
Blockbuster. Blockbuster. And this is where Blockbuster enters the story. So they go to Dallas, where Blockbuster is headquartered, Dallas, Texas.
They meet with them and they're like, you know, we need to sell the company. We want to sell it for fifty million. Fifty. This company's raised like a hundred and fifty million at this point. Like, imagine if this had transaction had happened. Blockbuster is like, eh, you seem kind of desperate. I don't think so. We're just gonna crush you. Unreal. Absolutely unreal.
Totally unreal.
So uh for the companies that made it through the dot com burst, you look at Amazon, you look at Netflix, you're like wow, they were really smart, really good capital allocators, were super nimble, were able to make it through this. Like Netflix tried to get out. They were like, look, we'll just cut our losses and and go be part of Blockbuster.
Blockbuster are not idiots. They're they're really not. Like they
At this point, C D V D.
um are already in the market and they also see the online subscription business model and how good it is. They're like, this is why they don't buy them. They're like, we could spend fifty million million dollars on buying you, or we could spend slightly less than that and just
copy you and build you and use the Blockbuster brand. And they build Blockbuster online, um which is a clone of Netflix. And it's really good. Like, you know, initially it's not so good and Netflix kind of makes fun of them, but like eventually like it gets really good. Yeah, like
The website was terrible. There's actually a really good a recommend uh uh so friend of the show, uh Caro over at Wandry, they they did an episode um or a little series called Business Wars that was about Netflix versus uh Blockbuster. And there's some epic episodes in there about Hastings and the rest of the Netflix team sort of like loading up the Blockbuster site when it first launches and laughing at how
They got Accenture to build it. They didn't hire their own engineers and like But they overcome it. I mean well think about this. It's Netflix, but
If you actually want a video tonight, you can just go return it to Blockbuster and then get a new one rather than waiting for this whole mail thing. Well, well, that comes up in one second. So initially Blockbuster Online is a true Netflix clone. It's separate, separate business, separate office building from Blockbuster. No
attachment to the stores because they franchise the stores. So the franchisee owner of the stores, they don't want
Blockbuster online to be cannibalizing.
their business. So that kind of becomes an issue in a bit.
Netflix though, they're like, All right, we can't offload this thing.
We're I guess we're gonna have to soldier through. So they do this is this the we're gonna say these things, but like
I want everybody to like really think about this.
They do a forty percent
Layoff a forty percent riff.
Of the company. Four out of ten people, they lay off. Remember, just a couple months ago, they were gonna go public and everyone was high fiving.
having lived through my first two years in the working world of the two thousand eight recession, like I know what this feels like. Like
Bad times are bad. Like we have been in good times for the last, you know, ten years. Imagine that, like forty percent of your co workers just gone in one day.
And Netflix does this, but this is what they have to do.
And the way that they did it too, he called a
immediate urgent company meeting.
They made this decision, he calls a an immediate company meeting and says
Forty percent of you are going to be laid off today. And then people go back to their offices to wait and see if their manager comes to talk to them or not.
Harrowing.
Totally harrowing.
But
Managed about as well as you can and um
You know, it's just like in times like this, it's either the company's gonna die'cause you're gonna go bankrupt, or you need to cut the burn. This is war time, you know?
And this was also is interesting, uh, reading that Netflix book, the way that Barry McCarthy sort of was looking at this is we need to do this
to prepare for the IPO not only from a cash burn perspective, like we've got
I think they ended up IPOing with fifteen million dollars in the bank.
Um, so they definitely needed that that mezzanine round that they thought was just gonna be to uh let those investors buy a little extra equity. But it was really about uh what story were they gonna go tell the street when they when they were able to be profitable in 2002. Yeah, and and I I think they weren't quite profitable when they IPO'd, but it was they were on track to be profitable the next year.
And you know, they needed to show that even if they were
a very lean organization and they needed to be to to be in this dot com burst era, that they could still execute their business.
Yeah.
And also when it comes to this, I mean like
Such kudos to again a terrible moment, but like
so many other companies would have been like, let's cut ten percent.
Then let's cut another ten percent and like thousand cut your way into it. McCarthy and Hastings are like no.
We're cutting to the bone. We're doing it right now. This is one example. There's another example we'll get to th in this episode. And then there's a third example that we're gonna save for the second part of this this Netflix set, but read Hastings and Netflix management.
Are
Awesome at executing these like we made a decision, we're gonna go hard at it. I know it seems insane, but
we have very sound logic for why it needs to happen and it's happening.
I'll foreshadow that the next two are related to uh
either spin offs or spin outs from that flip. Indeed.
Well
Okay. Uh
The next year, May two thousand two, they finally do the IPO. This is still nuclear winter for the
tech world. Um, but they need the cash. They've gotten the profitability. They're like
We're just gonna do it. We're gonna go public.
They raise eighty two and a half million dollars in their IPO at a market cap of just over three hundred million dollars. So they sell over a quarter of the company in the IPO.
Ooh, I mean like can you imagine that these days it's like seven to ten percent, like, you know
Like Well, and it's not it's they're not IPOing for three hundred million dollars these days either. I know, I know. Crazy.
Yeah, I joked to David and I messaged last night, like, wow, that's a really nice, uh nice series B post they IPO'd for. Seriously. Um
But the business is capitalized, right? And then, you know, they have no debt. They they they don't need to raise any more money and they don't
Uh they eventually do take on debt, but I believe not until the streaming era.
I think they did a tiny secondary the next month. Uh and and just sold a little bit more um in sort of a additional stock offering. But yeah, to to your point.
No nothing meaningful for a while. Yeah, they're fully capitalized.
So remember Randolph, the original CEO, and uh and Lo, the guy who was running the the video stores in Marin.
Now that the IPO's happen, they're like, Okay, great, we're gonna go focus on new things like initiatives within the company now. And they start testing kiosks, Netflix kiosks that they're gonna put in grocery stores. And they're like, This is gonna be a great new growth initiative. And Hastings and McCarthy, they're like,
Guys.

And actually Hastings at first
agrees about the problem they're trying to solve. So an important detail is that Netflix is convenient in a way because you don't have to leave your house, but it's inconvenient in a way that you can't have it now. Like they constantly were struggling with this existential problem of instant is not a part of our value proposition to date. And so you know this is sort of uh
Um Low and Randolph's brilliant idea of like maybe maybe this is the way to solve instant.
Maybe this is the way to solve this w maybe it is but
Eventually McCarthy and everybody they're just like, Guys, we just did a forty percent riff. We finally got public. We gotta stay focused. We there are no new initiatives that we're doing right now.
They kill it.
And wait, wait, before they kill it though, this is great. Uh, Lo and Randolph are so obsessed with this idea. The two of them so they've convinced a uh grocery store, a single grocery store in Las Vegas at Smith's Grocery Chain to work with them to do this. And this is so awesomely startup y.
They decide it's not worth our investment in figuring out how to actually build a vending machine that's gonna vend DVDs. So we are going to task a Netflix employee to just stand there behind a little like kiosk. It's a store within a store after the checkout of the Smiths grocery store and just like
people can come and and they will just do it manually and the employee will hand you the DVD, which is just awesome. And to oversee the things that don't scale. I know. Lo and Randolph actually got uh an apartment and moved there for a month.
to kind of like be a part of standing up this operation. I mean they were stoked. It is awesome, uh, as we will see. Um
But you can also understand why
McCarthy and Hastings are like guys, guys not now.
The second thing that happened before they killed it is that um Lowe went and w talked to the CEO of McDonald's and was basically like brokering a deal. It was like then he came back to uh and this this guy freaking loved it. McDonald's was like, we want to roll this out at all of our, you know, uh a little extra revenue for the people that are hanging out in our stores we're in.
And so Lowe brings this back to Hastings and Hastings is like, Are you freaking kidding me? Like our first brand impression with the majority of America that doesn't use us yet is not gonna be in McDonald's when they're waiting in line like that. No, absolutely not. And so part of killing it was like
Look, we don't have the headcount for this, we don't uh we can't split our focus like this, and now you're coming to me with McDonald's?
All right, David, take the curtain off. What did this become and how did it become that?
So
Randolph and Lo, they're demoralized. Netflix has changed so much. Randolph, you know, he started this thing, he was CO like
You know, it's it's time for us to go.
They go. Randolph gets full time into an investing and as as we talked about, chubby's and and and liquor and all that.
Low, he can't stop thinking about this kiosk thing. He's like, I'm gonna make this happen. He's like, I'm gonna start a company.
That company
becomes red box.
Which wild wild Which is now an actual very significant competitor to uh Netflix. Yeah. I actually don't know what's happened to it now. Like does it still exist in the streaming world?
I think it is now part of something called outer wall.
uh which is uh they own uh Redbox, Coinstar, Eco ATM
Gazelle, a bunch of these other things.
Outer wall stands for the outer wall of the grocery store. And it was basically rolled up. I think it's actually a Bellevue based company. Yeah, yeah, because Coinstar was in Bellevue.
Yeah, yeah, yeah. I think maybe Coinstar expanded to become Outer Wall when it rolled up all this other stuff. Something like that. But Redbox is now part of that, uh that private equity family. Yeah.
Crazy.
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Okay, so back to Netflix. We're now in March two thousand three. Things are going great. The company hits a million subscribers. They announced this on their earnings call.
Everyone's high fiving once again, as we'll see, this doesn't last long. McCarthy, he's like
This is great.
I've gotten landed the the plane
I really want to go be the CO of my own company.
I'm gonna leave by the end of the year and do that. But you know, I wanna give everybody plenty of notice, wanna give the street notice. Um so he announces that.
Almost immediately afterwards, Blockbuster fully launches they've been testing, they fully launch Blockbuster online.
The week that they launch Blockbuster online to the general public, Netflix market cap drops 60% in one week, like a rock. And as we said, like it actually becomes a pretty good product. Plus they have all the marketing power of Blockbuster.
And so what happens is very quickly
all of the market uh going to subscription based online movie rentals, DVD rentals.
Netflix was the only player until now. Every new customer in America who came to do this
I had to do Netflix.
Blockbuster gets fifty percent of new signups, so of new people coming into the market, which is where the vast majority of the market is still
Coming in.
Blackbuster takes fifty percent share immediately. Yeah, and if if you think about the the timing on this, so when when Netflix IPO'd they had five hundred thousand subscribers, it it's interestingly not that big of a number on the number of movies. It was eleven thousand five hundred movies, uh as they say in their S one. So
It's now two thousand three. Netflix is barely profitable. They just turned their first quarter profit. Blockbuster launches this. This is exact at the the crest of the DVD wave, where when Netflix is reporting earnings sort of the quarters before Blockbuster, they're like
celebrating on the earnings call like
There is now two hundred dollar DVD players. America is buying DVD players. Our bet was right. This is just fueling our business. This is amazing timing.
And so for Blockbuster to just nail it and and and launch it at exactly this time is like kneecap. Yeah, this this uh million subscribers that they have up from five hundred thousand at IPO is
You know, there's uh what, two hundred million households in the US or something like that. Like anything that happened before is irrelevant and what matters now is new signups in the future. Yep, exactly. Not only does that happen, they've got a second problem, which they're even more worried about. They get word that Amazon
And their one time potential acquirer.
is gonna come into the market and is working on building a Netflix competitor.
Remember, not streaming, we're still in the DVD rental market.
They announce this, they're like, We gotta be honest about this with the street.
They announced this on their Q three analyst call.
That they think Amazon is coming.
They're gonna get ready for it. And McCarthy says, I'm not leaving, I'm staying, I'm gonna stick it out and fight here. He actually says that I quote on the
On the investor analyst call.
You don't leave your friends in the middle of a knife. Which is just awesome. What a hero. Uh and uh uh and he literally like swashbuckling comes rides back in. In anticipation
Uh n not of of Blockbuster. Not in reaction to Blockbuster, but in in anticipation of Amazon coming in, because I think Amazon's gonna follow the Amazon playbook and just undercut everybody on price. Netflix cuts their subscription price by almost twenty percent. For the first time it's like sub twenty dollars for the the the big clan. Yep.
Unfortunately, this turns into a full on disaster.
A Amazon actually never ends up entering the market. They do in Europe, um, but not in the US.
Blockbuster sees this and they're like, Oh
Netflix is starting a price war. So now Blockbuster and Netflix get locked into a
Price war and Blockbuster further undercuts Netflix.
And things go like haywire.'Cause remember the cash burn cycle is super important here.
And Blockbuster has a much healthier balance sheet at this point too. So Blockbuster is like, Wait, Netflix just cut prices?
Why? Like we can outspend them. Okay, I guess we'll cut prices. Yep. Well, they can and they can't, as we'll see. So McCarthy and and Hasty, they're like
Okay, we need to model out exactly because Netflix has a bunch of Blockbuster has a bunch of debt um from their old stores and they used to be part of Viacom and then they'd spun out. There was a whole complicated transaction. So yes, they have resources, but they also have debt covenants. So they model out in detail
what they think the Blockbuster online business is, how long they think they can survive at this lower price and with all the promotions they're doing until they trigger their debt covenants. And so they're like, Okay, we think we have about six months. David, can you go into what w what debt covenants are a little bit? If you have debt, there are
Agreements on the debt called covenants that basically say you have to maintain certain financial
uh health metrics of financial health. If you
don't if you trigger those debt covenants, then you
the lenders, the people who own your debt can put you into default and push you into bankruptcy. So it's like you don't want to do that. Now you can go back and renegotiate with them. Anyway, lots of detail and all this happens with Blockbuster. And just to drive the point home and put a super fine point on the um on the cash cycle here.
Yes, there's a bit of million subscribers acquired. They hope to acquire, you know, another hundred million in the future.
they're dramatically accelerating marketing spend to be able to bring people on at a faster rate every quarter than they had been before. However, since the first month is free, they make no money on people for at least a month after they acquire them and they're spending a more money than ever before.
to get nothing for that first month. So it's like you know the uh to your point, that timing is tricky. Plus there's advertising dollars that you're spending to get those new customers. So what does Blockbuster do? They run a Super Bowl Netflix is like, oh my God. Um but they keep cool heads. They're like
The market is still growing, we're still getting subscribers. If anything, Blockbuster is just educating the market.
They don't cut prices further. They don't get further drawn into the price war.
And it basically works.
Because we will see here.
The if Barry McCarthy is the acquired superhero.
The acquired super villain.
Steps into
The scene here. Carl Aiken. Of Marvel fame, of uh where else has he showed up in our episode so far? Uh I don't think we've talked about Matthew is with Apple with a lot like
This guy. Oh my god.
Shareholder activist shareholder.
He gets super involved with Blockbuster. He buys about a 17%, either 17 or 19% stake on the public markets in Blockbuster, starts agitating.
w fi files a proxy battle to basically at the Blockbuster annual shareholder meeting to
uh elect a separate slate of board directors that are all of his cronies. He wins
Crazy. Again, Blockbuster is actually like
being smart here, their management is actually pretty good. Carl Iken just like replaces the whole board with like
I can cronies. He starts bringing his son to board meetings, who's just like
Some twenty-six year old dude and he's like, You should give product feedback. It's insane. But for the the the Blackbuster management, they managed to kinda like keep things
On track, and they decide with all this going on they need to raise prices back up. Um, so Netflix and Blockbuster both raise prices back up.
The tide is rising, both companies are coexisting here in the market. Things go pretty well. Netflix is still the leader. They end 2005 now. They have over four million subscribers. They have a market cap of over a billion and a half. So up, what's that, five X from the IPO three years ago.
They launched the Netflix prize in two thousand six that you alluded to, which is we probably don't have time to cover it in a
full detail here. Maybe in the maybe in part two.
But super awesome, get a ton of PR. Can any brilliant computer scientists out there
beat our algorithm by what is it, ten percent?
Ten percent. Yep, yep. Yeah.
Everybody thinks that like it's gonna happen very quickly. Ends up taking like three years before
It finally does get uh
It's two thousand nine, I think, when the when the prize is finally awarded.
But anyway.
All this is happening.
Blockbuster, like they're still growing, but they realize like the bricks and mortar business is is
you know, not long for this world online. And we're now in the mid two thousands
Um, they really need to go all in, management decides on online. And they think what is what is the one thing we have that we can beat Netflix on? They've realized that the turnaround time on rentals is super important. And this is actually pretty brilliant. They come up with this concept called that they mark as total access.
Which is essentially you sign up. Yeah, this is at the at the end. You sign up for Blockbuster Online, which is essentially just a Netflix clone.
And the the
Extra that you get.
Is
you can now return your movies to any blockbuster store.
And exchange them for your next movies at the store. So this is like what Amazon is doing with um, you know, Amazon Go and Prime Now, and like this is actually like pretty visionary. It it's risky because it does involve a lot of capital, a lot of ops. Um, you know, it's it's like people are very skeptical that this could work, but if it does,
Netflix can't match it. They have no physical footprint. Um, and Blockbuster has stores all across America. Netflix is super, super scared when this happens. This is in two thousand six.
So scared that at Sundance in the beginning of 2007,
Um well and it gets scared, it actually makes a huge impact. So
Netflix growth flatlines, not only do they stop growing, they start losing subscribers. Uh, this has never happened. Like remember, they've just been
Adding subscribers, you know, quarter after quarter after quarter. It's like watching Snapchat or something. Totally. This is like this is the Instagram stories moment. Um
And
They're so worried. Sundance two thousand seven, Reed Hastings meets with the Blockbuster CEO and he offers
Essentially a merger.
of the two companies and he says Netflix will buy
Blockbuster's online business from you.
for six hundred million dollars. So it'll be essentially like uh I guess what's that like two thirds Netflix, one third Blockbuster is the ratio I assume it would be all stock. And Blockbuster rejects it. They're like, no man, we got you guys on the ropes. We have a structural advantage you don't have. We're back in the game.
And then history like turns on a knife point. This is crazy, like
Blockbuster was gonna win if they could execute this.
But Carl Iken.
Oh my god. Oh my God. This is literally this might be the worst self-inflicted wound in like the history of business. This makes like the Uber thing look like child's play.
Carl Iken and the Blockbuster CEO get into right around this time get into a huge fight over the CEO's annual bonus.
And such a fight that the CEO resigns
And and I can push them out.
Iken then hires a new CEO, this dude from seven eleven.
Who this can be and to be clear, this is Icon scrutinizing the CEO's proposal for his and other executives
bonuses and saying, Nope, I don't see why you should be paying yourself that much. Yep, exactly. And the Blockbuster CEO's like, I'm like successfully navigating this. I'm about to beat Netflix. They just capitulated. They just offered a merger and I think I'm gonna beat them. And uh
The
This guy who Carl Iken brings in. I I don't even remember his name. It's not worth it.
Basically like i we try to be pretty even and balanced on acquired.
This guy is a total idiot. Like he is a complete
Moron. This is this is like he doesn't he's he says he doesn't believe in online businesses.
This is two thousand seven. Like it's pretty clear that online businesses are a thing. Google has been public for three years, like, you know, this is insanity. He doesn't believe in online businesses. He his plan
He's gonna totally defund Blockbuster online. He thinks Netflix is a joke. Nobody's gonna do it. Uh he wants to bring back the heyday of bricks and mortar. Wants to make bricks and mortar great again. He wants to attract back coal, David. He wants to attract the kids.
to come to Blockbuster stores by selling pizza and soda at the stores. He has a plan for this. He calls it
Rock the block.
God, if you were to read Hastings, it's like you're gonna hear this music just have your jaw drop and be like we're saved. We're saved. Here's the kicker. Here's the kicker. I remember this. I was working on Wall Street when this happened.
Circuit City.
Is
Like
on the brink of bankruptcy. Uh Best Buy f does manage to survive this, but they're also at the brink of bankruptcy. Amazon is eating everybody's lunch. Again, online businesses, they work.
The C this new CEO of Blockbuster, he's like
We're gonna buy Circuit City for a billion dollars
You literally cannot make this stuff up. And You know what's better than than than one failing business? You put two of them together. We're gonna tie two anchors together and drop'em into the ocean.
Oh my God. It's it's ridiculous. Everybody it doesn't actually happen because even Carl Ichen is like, I'm not sure that's a good idea. Um Have you have you been to one recently? Yeah. So
Basically everybody good at Blockbuster who was running the online business, they just resign. And it's crazy. Like in the book, they talk about the guy who was running the online business. He was really good. After all this happens, Reed Hastings calls him up and he's like, Hey, let's like get dinner.
And they get dinner and they talk about everything. And then he invites him out to Netflix. He does like a town hall at Netflix and they talk about the whole history and what Blockbuster Online was doing, when Netflix was going.
It's crazy. They all resign.
We know what happens. Blockbuster goes bankrupt. All of the momentum they had around total access, it just dies. They defund the whole thing.
Netflix wins. And it's amazing because like all of this again, once again, Netflix was at the brink of death, a miracle happens.
All of the marketing, all the buzz around
Total access for Blockbuster, that just brings so many more people of the mainstream in America into this market. They all go to Netflix. So by spring of 2009, Netflix now has 10 million subscribers.
They're thriving. Nobody's canceling during the recession.
They're on the top of the world. It's amazing. And that
Is where we're gonna leave part one.
Because there's another thing on the horizon coming.
I thought Netflix was such a like stable, boring business. So not the case.
You can't stay on your Laurels for long because streaming is coming.
What a good place to leave it. When we were going back and forth last night on where should we leave it. Should we uh should we go into quick stir or not? I'm really glad that we uh uh this feels like such a good place to to hang.
Uh, totally. I just like
Circuit City. Circuit City.
Uh
I mean again. Like
The worst. The worst.
Um
Alright, I'm emotionally exhausted, but we have other sections.
Should do narratives?
Yeah.
Going into narratives, I want to recap just a couple things from reading the the S one last night because I think they're interesting.
Um so they sold twenty seven percent of the company in this IPO, raised eighty two point five million dollars.
no net income yet, all only net losses, but about to have their first quarter of net income.
The cap table is fascinating. So Reed Hastings owns twenty percent of the company.
uh which will get diluted down to about fifteen percent after the IPO.
T C V technology crossover ventures in in two different vehicles I
I'm pretty sure I'm reading this right, has forty six percent of the company.
Yeah.
Crazy.
Pretty rare to see that at at IPO.
A single firm with different air much ownership.
Totally different era.
you look at what they did there, they they were able to uh to raise, you know, I think in that with including that second little offering, close to a hundred million dollars.
They made no real promises in their S One about sort of what they were gonna do with that in any sub substantial way. They sort of just talked about
they were gonna spend on marketing, they were gonna spend on improving the technology, they were going to increase the the selection that they had. I mean, it wasn't like when we talk about what did they do with this
this capital. They run a flywheel business, so they just had to pour more money into the flywheel and and have more money to be able to accelerate it. You know, in in looking back, we we tend to do these this narrative section where we do bulls and bears.
Unlike other times like Facebook or like the nep the um Snap IPO, it's not like there were people running these articles of of doom and gloom. I mean it was pretty
Hey, this thing seems to be going pretty well. It's pretty disruptive. It's not clear if it's gonna work yet, but they're IPO ing it's not a huge IPO.
Well, to jump into the bear case here.
All that's true, and like yeah, I mean if you really looked at it like
This was a really good business. I mean there was potential headwinds in the future of Blockbuster. It was
It was one of the only tech companies
Uh,'cause people just watched all these dot coms go bust. It was one of the only tech companies that was posting v, you know, nice financials and was about to be profitable. I mean, there's like this huge, you know, wow, it's a real business. You should buy it.
Yeah.
But I think the bear case is is
Yeah, people are just still so, you know, God human psychology hangover from the the IPO crash. They're all like, Oh, this CEO like was the largest merger in you know Silicon Valley history in the bubble era, and now like you guys are losing money and like I don't believe in online businesses, you know? And also to be fair a fair bear case was
I don't know, don't count out Blockbuster.
And as we've seen, Blockbuster very well could have won here. Um, you know, hard to know.
But yeah, the bookcase, like you said, like this is a good business.
Subscription businesses like
Could be a thing.
If if they work, if you can get them to work.
They can be very challenging to scale, but like this is why cable companies are so good in cable companies. We'll come back up in part two uh of the episode. Like if you can get
consumers locked in to paying you a certain amount every month. Like
You can
build a very stable, very predictable, very good cash flow business around that.
Yeah.
Alright, what would have happened otherwise?
Let's do it.
I struggle to find any other way that
this could have worked out for Netflix.
I mean th they either would have ended up
Part of
Amazon and I'm not sure they would have maintained the brand part of Blockbuster and they would have
killed it, that would have been a tech. Yeah. Um
If they hadn't
opportunistically raise some cash right before they thought they were gonna IPO, then they probably wouldn't have weathered the storm. If they didn't IPO when they did, then they probably wouldn't be able to um properly fight Blockbuster. They didn't do the forty percent layoff, like you know. Yeah.
Just a lot of things went their way here.
Company is its skill and luck.
Yeah.
Totally, totally. I I think maybe there is a world where they could have kept
Delay the IPO longer.
you know, they were at profitability.
That would have been the wrong decision, I think, because Blockbuster is coming into the market. And access to capital in the private markets didn't exist like it exists today. Yep. Totally.
Yeah, they had to do this.
Yeah.
Tech themes.
Let's do it.
Um the first one that I'm thinking of is like
And it we've beat this to death on this episode, so it's not gonna be like surprising to anyone, but Tabula Rossa, if you come up to me and said what wave did Netflix take advantage of to to really launch them as a company, I'd be like streaming. But like the fact that DVDs were a wave
is il still a little bit mind blowing to me that I I it it it's just very uh
Think how fast as humans we forget the very recent past and what was uh a big deal and what wasn't is is striking.
Totally. And yeah, just timing, like
Not only a big wave, but like Netflix timed it.
So perfectly. Um, and this is why we ended up breaking this episode into two. Like these are two different businesses, the DVD part of Netflix and well
Foreshadowing Quickster. They really are two different businesses. Did you know you can still go to DVD oh actually they so they bought the domain. Netflix has DVD.com.
Uh you can go and access their DVD offering there.
Huh.
Interesting.
Yeah.
Wow.
Wonder I mean there still are people who
I think they still have a few million D V D subscribers to this day. I think and interestingly enough, from D V D dot com this is how muddled this stuff gets, you can rent Blu rays.
What about Divics? Double.
Um okay I have a couple of
The biggest one, though, we
We glossed over a lot of stuff as we had to in this story. Um, this is part of why we're doing
our L P program and bonuses is to get deeper into like
Who are the people that like actually build these things and what are the uh decisions along the way that like operationally
Help make all this happen.
But one thing that
Again, we didn't get to cover as much in this episode.
that I think is an interesting theme both across Amazon and Netflix is that
The
People in finance and marketing, and we did talk about McCarthy at at Netflix.
At these first generation internet companies.
were so good. Like
Barry McCarthy, Joy Covey at Amazon, uh, Leslie Kilgore, who ran marketing, analytical marketing at Netflix. Like we didn't get to talk about her, but there are so many people that are just like really, really, really good. They tended to come from
um like the CPG world, like from Procter and Gamble. And I think that's where Leslie Kilgore came from. I could be wrong on that. But there are a bunch of these folks on Amazon, bunch of these folks in Netflix, um
And they're just so good. And I feel like that's like a
That's like a piece of DNA that's now missing in the valley.
is like this combination of finance and marketing. You know, and there's like growth, quote unquote, which is sort of the successor to this, but um cowboy marketing. Yeah, it's become so cowboy and it's become also just so dependent on Google and Facebook. Like although the good growth people would find ways and tell you that their way isn't dependent on Google and Facebook. And there's still ways to there are still good people, but you know
This is the
Barry McCarthy modeling out Netflix's online business to a T, like he knew what month they were gonna have to raise prices. The the Netflix program with consumer manufacturers uh of of uh consumer electronics manufacturers to put the coupons in the boxes.
and modeling out exactly what was that was gonna cost, exactly what their growth rate was gonna be, you know, the going
population uh not um subscriber center by subscriber center with the with the one day delivery being driven by where
Word of mouth is occurring, like all that stuff. Like that's the company building stuff that built
Netflix into like a great business. And Amazon did the same thing, so
That's what I wanted to call out here.
I have two trends that I wanna call out that were uh stated in the S one because one of the things you commonly see in these S ones is it's a area called trends, but it's basically why should you believe that the wind is at our backs.
And one is one that I hadn't really thought about that much, which was the very first one they call out is the shift to viewing in home instead of in theaters.
And I had forgotten about this because this was like in the era I think it was a little bit before the era where
piracy really accelerated people not going to movie theaters, but there was already a trend where people were like, gosh, why you know I can go rent it at Blockbuster. Why would I
you know, I'll I'll I'll wait to see it on video and it'll be cheap on video. And this was killing movie theaters, but this trend was starting to accelerate, and that was one thing that they cited that it was like, look, no matter how people are renting movies, like they're watching them at home, and that's really helpful for us.
Which I thought was interesting.
And the other that they cited was in uh slightly different words, but the paradox of choice that it was really hard so
There's one of two things will happen. You go to Blockbuster and you're mad that there's not enough selection or the movie that you want is out.
Okay, if you go anywhere where there's infinite selection, then it's in it's too hard to choose what movie that you want to watch. But they had Cinematch and the Cinemach algorithm was really good at telling you what movie you probably want to watch next. And so they actually cited that as a sort of trend and advantage to Netflix in their their S one shareholders, which was interesting.
And I've got a few more, but we're gonna save those for part two.
All right.
It should be great.
This and we're gonna grade the IPO here.
Yeah.
So I was thinking about this and I'm like, Okay, w l let's say they didn't'cause we've already covered like
they n s they needed the IPO to have the cash to be able to win the war that they won, and they were close to losing the war against Blockbuster. So
Even that aside, okay, why IPO? What's the point of that? You've got the the the cash position they're sitting in is fifteen million in the bank. They're not gonna be profitable this quarter, but maybe the next, and it's gonna be super thin. So like you need cash from somewhere. W why does this business need cash? And what is the flywheel? I think the flywheel is
More spend gets you more customers.
Which gives you
more leverage with content providers, which isn't really a huge factor in their business yet, but there there's gotta be some element of yeah, buying, you know, they're already buying DVDs in mass, so they sort of need to be able to um do that to serve more customers and you can buy deeper in the tail when you have more customers. They eventually do deals with
um movie studios as they get bigger to buy DVDs at a discount.
Yeah.
So that gets you more and better content, which then makes you able to inherently that improves the product offering, which then lets you go get more customers. And so I mean it really it's it's a flywheel business that they're they're raising cash to pour onto it. So
competitive stuff aside, they should have just gone out and raised as much as they possibly could have to be able to fuel that that flywheel faster.
They sold twenty seven percent of the business. Like
Good move. I mean, that it's not like they could have raised any more and it doesn't feel like the stock price could have been any higher given the uh macroeconomic climate they were in. So
The way I look at this.
They raised the most money they could, which was the good idea.
Even if they didn't need it for competitive reasons, which they did, it w it was a good idea timing wise and uh and amount wise. So
You know, it's not an A plus for me because those are reserved for exceptional circumstances, but this is a solid A.
Yeah, I think
One thing I wanted to add on to the the flywheel aspect.
We thought about this a lot at Rover, actually, um, which is not a subscription business, but has some of the same dynamics.
With a business like this, subscription business
Once you grow to a certain point,
As you're growing, you're spending a ton of money on customer acquisition, bringing new people in. And as we talked about in the early stages of the market, so much of the market has yet to come.
There comes a point where you flip from all of that money that you're spending on customer acquisition, you're not making that back in terms of the
revenue you're getting from your subscribers. You're spending more than the money you're getting back.
But at a certain point in the market, in the adoption phase,
That flips where
you are now you're still spending as fast as you can, but your subscriber space is so big, they're generating so much cash that you now like your economics tip over into the positive.
Once that happens.
you can super quickly go from like a, you know, cash burning business, as we saw, to like an incredibly, immensely profitable, immensely big moat. Because for anybody else to come compete with you, they'd have to spend the same amount that you spent along the way to get there. Um now Blockbuster could credibly do that, Amazon could credibly do that, but nobody else could
And
Once
Netflix did that, that's when
As far as the DVD business concerned, uh was concerned, uh, that's when they tipped into like, we are a awesome business, very stable cash flows. It's the same thing with cable companies. This is how they work, uh or worked.
So yeah, I think it was like they absolutely needed that capital to do that. I think, yeah, I debate A or A minus. Um certainly A range because they needed to, they executed, it was great, they did what they had to do.
Just the market conditions were so bad that like selling that much of the company, like, you know, um, so so not ideal. But I don't think they really had any other choice. So I don't know, A or A minus.
All right, carveouts?
Carbon's.
Okay, so mine, uh I'll go
Uh quickly.
Uh I can't believe it's taken me this long to
Read and then recommend.
Uh N K Jemison's sci fi trilogy, The Broken Earth trilogy.
These books are amazing.
Amazing. If you haven't read them yet, if you're a sci fi fan, even if you're not a sci fi fan. So three books in the trilogy.
Each one of them the first one won the Hugo Award in two thousand fifteen, I think.
uh fifteen or sixteen, the second one won the Hugo Award the next year, the third one won the Hugo Award the following year.
So, so so good. Um
And just like a perfect societal commentary for
you know, the era we're into where like it's a a persecuted people have an immense power that uh
can save the world, uh, but they're persecuted and like so you have to get p anyway, it's really, really good.
Must read.
I have one I had a list of articles that I've read recently that I thought were good, and then I was like, you know, I should do one that's just like something kind of fun. And I thought it was gonna be completely unrelated to the episode, but uh I'm now realizing it's not at all. There's a Netflix show that I've been watching called The Good Place, and uh it's with Kristen Bell
It is really goofy, but really good, and really good sort of just like popcorn, uh, you know, watch it for half hour before you fall asleep. It's that it's it's basically like a a heaven and hell uh thing where
Kristen Bell lands in the good place and she's looking around and she's like, Oh cool, I'm in the good place.
So I'm not in the bad place then and she's like talking to the administrator of the good place. And it's it's just like it's very tongue in cheek, but um
Really good. And uh uh when I picked it I didn't realize that it was a Netflix show, but um Netflix original content coming soon and and in a next episode.
Awesome.
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