Netflixed

by Gina Keating

  In contrast to the amiable Randolph, who disliked having to take his managers to task for missing budget targets and project deadlines—let alone firing longtime colleagues—Hastings seemed to lack an empathy gene.

  His new colleagues at Netflix observed that, along with his brilliance and much needed decisiveness, Hastings brought an uncomfortable level of process and formality that began to wither the little company’s spontaneous creativity and cheerful disorder.

  Chris Darner, a New York University film school graduate hired by Randolph as a product manager, was struck by the difference in tone and approach to customers once the “left brain” engineering mind-set began to dominate at Netflix.

  “It went from being a futuristic utopia, where there were people who played flutes on the hill because the people had decided it was important to play flutes on the hill, and [we’d say], ‘Reed, wouldn’t it be great to have some flutes on the hill, and some unicorns?’” Darner later recalled. “And Reed would say, ‘Let’s just put a speaker up there and a cutout of a unicorn.’ In his mind it’s the same as having the real thing.”

  To the growing contingent of software engineers, however, Hastings was a rock star, a boss with the charisma to gather the smartest people he could find and set them into a productive competition with each other. Rather than the creative family Randolph had gathered around him, Hastings likened the company to a professional sports team, in which players won time on the field on merit alone. Some found the analogy inspiring—others, suffocating.

  The “two in a box” co-CEO concept called for Hastings to take over the company’s engineering work—the Web site and the back-end infrastructure and fulfillment mechanisms. Randolph would oversee the Web site design, customer service, and content acquisition.

  Ceding control of Netflix was difficult for Randolph at first. While the founding team grumbled that Hastings had pushed out Netflix’s rightful leader, Randolph tried to be philosophical about the arrangement. He had what it took to conceive and launch Netflix. What came next—ruthless optimization and relentless growth—were not his strong suits.

  Netflix badly needed a large cash infusion and some hard decisions made about its direction, and Hastings could handle both tasks better.

  Although the venture capital community poured a then record $5.4 billion into Silicon Valley start-ups in 1998, and interest in dot-coms was still climbing, investors were becoming wary of companies with no clear path to solvency and profit.

  Nevertheless, when Hastings started making the rounds of the venture capital community he found checkbooks opening for him based on his success with Pure Atria. He also considered opportunities to sell Netflix but found no offer large enough to return the capital that he and others had already invested.

  They had to solve their retention problems fast and get out of DVD sales before high-volume retailers got in and crushed them. Hastings made it clear to Netflix’s executive team that they were pulling out of DVD sales even though it was providing the company’s only profit. They were on notice that they had to find a way to make rental work, or the company would go down.

  Randolph and Hastings flew to Seattle and met with Amazon founder Jeff Bezos, who had indicated that he wanted to explore a partnership with Netflix. The two CEOs were willing to trade their DVD sell-through business for a crack at pitching online DVD rental to Amazon’s customers. Hastings also wanted to discuss selling Netflix to Amazon, if the price was right.

  While Randolph and Bezos hit it off immediately, trading launch-day stories, Hastings was less than impressed with Amazon’s $12 million offer. Instead, they agreed to a cross promotion—Netflix would direct customers who wanted to buy DVDs to Amazon in exchange for placement of Netflix ads on Amazon’s Web site and a royalty for each recommendation.

  The arrangement went down hard at Netflix, where some team members felt Hastings had acted prematurely in ceding DVD sales to Bezos. Kish, charged with customer retention, objected vociferously to the plan. The idea of sending customers to a competitor’s Web site undermined everything she was trying to accomplish, and violated every tenet of marketing.

  After announcing the Amazon deal in November, Randolph made the same offer to Mark Wattles, founder and president of Hollywood Video. The two men met in a coffee shop during a trade show in Las Vegas to discuss a collaboration. When Wattles asked about buying Netflix, Randolph replied, “I’m not sure you want to spend what we think we’re worth.”

  A few days later, Hollywood Video announced it had purchased Reel.com, the online arm of a Berkeley, California–based video rental store owned by Stuart Skorman.

  Reel.com had a library of eighty-five thousand VHS titles and Web traffic of about twenty thousand users per month when Hollywood Entertainment bought it for $100 million. Skorman considered online rental “a messy little business,” and not a very profitable one, but it was essential for habituating consumers to ordering entertainment online. Skorman was not just thinking of VHS or DVD but video on demand, a movie rental option that cable companies were starting to offer. Like Hastings and Randolph, Skorman had an inkling that one day consumers would shop for entertainment primarily online, and the portal they chose now would have a big advantage.

  As a result of the acquisition, Reel.com had access to Hollywood Video’s twenty-five million customers, and also directed its own online visitors to its new parent’s one thousand U.S. stores—making it a formidable rival to Netflix. Reel.com’s traffic jumped to two hundred thousand per month after the deal became public on July 31, 1998.

  Lowe and Hastings met with Wattles shortly after the merger to explore a cross promotion involving online DVD rental. They explained that a hookup with Netflix would allow Hollywood Video to avoid the costs and risks of converting its stores’ inventory to the new DVD format. The stores could slowly build DVD inventory as the format caught on, focusing on the new releases that made up most of their business. In the meantime, Netflix would fulfill requests for titles from the back catalog by mail.

  Wattles turned them down flat, insisting that he could build a DVD rental service using Reel.com. Meetings with Viacom-owned Blockbuster went nowhere—the giant renter’s executives pointed out that VCRs were still selling at a clip of thirteen million a year.

  To Lowe, who had arranged the meetings with Blockbuster and Hollywood Video, the rejections underscored a growing sense that there would be no easy way out—no white knight to ride to Netflix’s rescue. They were truly on their own in solving the company’s money and customer retention troubles.

  The Christmas season held equal parts joy and anxiety; DVD player prices dropped below two hundred dollars a unit, as the year wound to a close, and became the fastest-selling electronic product in history. Tucked inside millions of DVD player boxes were coupons for free Netflix rentals that waited like tiny incendiary devices to burn through the company’s dwindling cash and leave it in ashes—unless they could find a way to start making money.

  CHAPTER THREE

  THE GOLD RUSH

  (1999–2000)

  ALTHOUGH HE MAY HAVE HAD problems connecting with some of his new employees, Hastings had big fans among the investor community, and that is where he turned for help in early 1999. Netflix had posted an $11 million loss in 1998—not unexpected or particularly large for a start-up. But the rate at which the company was burning through funds was both impressive and alarming.

  Netflix had exacerbated its cash-flow problems with the decision to punt DVD sales to Amazon. It needed money—and a lot of it—to make good on the free-rental coupons that started flowing in from Christmas DVD player sales. The most urgent needs were to build DVD inventory and to hire new programmers to keep up with the Web site’s exponentially growing traffic.

  By January 1999, 1.1 million DVD players had been sold, and sales stayed on track to reach 4 million by year’s end. The costs of building Netflix’s DVD l
ibrary, now grown to three thousand titles, rose along with the adoption rate.

  Randolph started designing and scheduling tests of new features and business models in hopes of showing would-be investors some progress in solving the retention issue.

  Randolph and Meyer had designed the Web site to double as a market research platform that could display multiple versions of a page or feature to test groups of customers and gather detailed data on their reactions and preferences.

  A typical A-B test involved measuring the effect of a red logo (choice A) versus a blue logo (choice B) on acquiring a customer, and their lifetime value, retention rate, and usage. Randolph particularly loved building market tests with the Web site engineers, and he insisted that the tests be conducted meticulously, with one variable at a time, to avoid confusing the results.

  The constant testing, gathering of consumer input, and subsequent adjustments to the site formed an ongoing conversation between Netflix and its customers that would provide a crucial advantage in the coming battle with store-based renters. While Hastings pushed for metrics alongside Randolph and the marketing team, the answers were frustratingly slow in coming, and he became impatient.

  Randolph and Kish knew from relentless focus groups and A-B testing on the Web site that customers enjoyed their visits to Netflix and understood how to use the site. But their main customers—the coupon-wielding buyers of DVD players—often would not plunk down their plastic and actually pay for rentals when their free disks ran out. There seemed to be no solution for failing to convert the free offers to sales, and it consumed them.

  As Netflix’s first birthday loomed, the marketing team tested new software that allowed them to personalize e-mails to consumers to prod them to return to the site, sending reviews for movies they had just rented or suggesting films they might like, based on past rentals.

  The prevailing Internet industry belief was that content-rich sites attracted repeat business, so Randolph hired popular film critic and historian Leonard Maltin of NBC’s Entertainment Tonight to write a monthly online column exclusively for Netflix about new DVD releases. The company signed deals to cross promote with Sam Goody/Musicland stores and Best Buy.

  • • •

  HASTINGS AND RANDOLPH again made the rounds of venture capital funds that by early 1999, as the economy cooled, had started pulling back on their record-setting pace of investment in dot-com start-ups. In contrast to similar meetings a year earlier, in which Hastings made introductions and sat back as Randolph presented, Hastings now took over pitching Netflix.

  Randolph noticed the eager interest with which the VCs received Hastings, no doubt recalling the spectacular return he generated for them two years earlier with Pure Atria’s record-setting merger. Randolph knew he had less stature, as an unproven chief executive, in Silicon Valley’s “bet the jockey, not the horse” culture, and he was grateful for Hastings’s influence.

  He was losing control of Netflix by inches, and sitting in the investors’ offices that spring, he knew there was little he could do to stop it. The co-CEO experiment had ended with Randolph demoted to president in late 1998, and then to executive producer the following year, ostensibly to foster investor confidence that a proven CEO was at the helm.

  Hastings became chairman, chief executive, and president, and after resigning as TechNet’s president, took over as the public face of Netflix. They had argued about whether Randolph should sit on the newly formed board of directors. Hastings had wanted the seat for an investor, but Randolph had insisted on keeping it for himself.

  The founding team Randolph had assembled was slowly drifting away, demoralized or picked off by Hastings and McCord to be replaced by staff members chosen by and loyal to Hastings. By mid-1999, the company’s head count had been pushed past one hundred, and—with McCord having trouble convincing programmers to drive over the hill to work in Scotts Valley—Netflix went looking for bigger digs closer to the heart of Silicon Valley.

  In a final capitulation, Randolph gave up his dream of working almost within walking distance of his home and moved the operation into a nondescript, low-slung building on University Avenue in Los Gatos, the southernmost town in Silicon Valley.

  The other members of the founding team saw Randolph being pushed aside with mixed feelings. They had poured their energy and creativity into Netflix at a fraction of their usual salaries for two years to bring their dream company to life, and they wanted to see it succeed. Founders often had to step aside to let corporate “grown-ups” raise their babies—that was just how Silicon Valley worked. And Randolph seemed to take it with equanimity, plunging ahead with plans for a full roster of consumer tests and battling unreserved by Has- tings, as he always had in staff meetings.

  • • •

  IN EARLY 1999, French luxury goods tycoon Bernard Arnault approached Technology Crossover Ventures cofounder Jay Hoag for advice about investing in dot-com companies. Hoag, a former fund manager whose earliest investments as a venture capitalist included Pure Software, pointed out Hastings’s latest enterprise and scheduled a pitch meeting at his office for Arnault with Hastings and Randolph. Arnault’s holding company committed $30 million to Netflix in July, becoming its largest investor just as the company was about to run out of money. Hastings raised more than $100 million from venture capital and angel investors over the following eighteen months, including Hoag’s TCV, Foundation Capital, and Redpoint Ventures—a feat that Randolph, though a proven entrepreneur, admittedly could never have matched.

  Hastings now held Netflix’s reins firmly in hand, and the VC money gave him the power to begin shifting the company’s culture away from Randolph’s family of creators toward a top-down organization led by executives with proven corporate records and, preferably, strong engineering and mathematics backgrounds.

  With McCord in place to recruit and purge, Hastings proceeded to transform Netflix’s executive staff as soon as the Group Arnault deal closed. The founding team soon learned that those leadership positions were not open to them.

  Jim Cook, who had asked for a shot at becoming Netflix’s first chief financial officer, left after Hastings asked him to continue instead as VP of operations. Smith soon followed, and Bridges too wanted an escape from what he considered the “lather, rinse, repeat” routine that took hold. Kish, exhausted from two years of sixteen-to-twenty-hour days, and demoralized at the direction the company was taking, went on an extended sick leave to combat a chronic health problem and never came back full time.

  Hastings hired forty-five-year-old W. Barry McCarthy, Jr., an ex–investment banker and chief financial officer for the cable and satellite music-programming service Music Choice, as Netflix’s CFO, on April 19, 1999. McCarthy, who lived in Princeton, New Jersey, had first heard of Netflix and Hastings when he got a call during a ski vacation from a headhunter. He was impressed enough with Hastings’s credentials and the freedom promised him that he accepted the offer a week later, for the relatively anemic annual salary of $170,000 and the prospect of a $20,000 bonus, if he did a good job.

  McCarthy was smart and tough and made a practice of not tolerating stupid mistakes—his own or anyone else’s. He had a volcanic temper that could erupt suddenly from his normally controlled resting state, making his profanity-laced outbursts doubly alarming when they came. He proved a perfect foil for the icy Hastings, who seemed to respect McCarthy’s shrewdness in market matters and his ability to say no and mean it.

  As ambitious as he was, McCarthy retained an old-style loyalty and sense of corporate hierarchy that dictated a respect for Hastings and Randolph, whom he addressed as “Mr. Founder,” as well as strict ideas about running his company transparently and for the long term.

  McCord unwittingly recruited Tom Dillon, a former colleague from Seagate Technologies, to run the fulfillment operations in Cook’s place at around the same time. Dillon was chief information officer at flat-panel dis
play maker Candescent Technologies when McCord called to ask him to recommend someone to remake Netflix’s operations. He faxed in his own résumé that day.

  Dillon connected with Hastings immediately. He was a self-taught programmer with a long career in warehouse management, and often hacked the operating systems of his warehouse machines to customize them. He liked that Hastings used a mathematician’s approach to solving business problems in the most logical manner possible, and possessed an engineer’s loathing of personal drama. Dillon was tall and burly and had snow-white hair, as well as a gruff demeanor that masked a mischievous sense of humor.

  Randolph and Hastings initially hesitated in hiring him, worried about both the small salary and that Dillon, who had run international operations for Seagate, would not be hands-on enough in the Netflix vault warehouse, which lacked automation and had a tiny staff.

  Dillon, then fifty-five, assured them he wanted to be around smart people who were doing something fun and interesting, and Netflix looked like the perfect opportunity. He signed a contract at a third of his normal pay rate as a show of good faith, and officially was hired the same day as McCarthy.

  Before he started, Dillon called an old Seagate colleague who had been running Netflix’s distribution on a contract basis. “It’s not going to make it,” the guy told Dillon. “They’re shipping two thousand movies a day, and they have to ship one hundred thousand a day to break even. That’s not going to happen.”

  Well, it may crash and burn, but you never know, Dillon thought.

  One of the worst drags on Netflix’s bottom line was the way the company assembled and shipped orders, a process that cost six dollars per order in labor, transportation, and postage costs. Dillon’s first task was to cut that to below the two dollars they were actually charging for shipping.