That Will Never Work

by Marc Randolph

  We had our idea. Now we just had to figure out how to pay for it.

  When you start a company, what you’re really doing is getting other people to latch on to an idea. You have to convince your future employees, investors, business partners, and board members that your idea is worth spending money, reputation, and time on. Nowadays, you do that by validating your product ahead of time. You build a website or a prototype, you create the product, you measure traffic or early sales—all so that when you go to potential investors, palm outstretched, you have numbers to prove that what you’re trying to do isn’t just a good idea, but already exists and works.

  For instance: A few years ago, when my son graduated from college, he moved out to San Francisco with a buddy of his, intent on starting a new company. In less time than it took to drive from our place in Scotts Valley to San Francisco, he had built a website on Squarespace, set up a credit account on Stripe, bought some banner ads using AdSense, and set up some cloud-based analytics on Optimizely to measure the results. All within a single weekend.

  (One of the ideas they tested? Shampoo by mail. What can I say, the apple doesn’t fall far from the tree.)

  But back in 1997, you could raise $2 million with a PowerPoint. In fact, you had to. There are a lot of reasons for that, but the most fundamental had to do with time. In 1997 there was no Squarespace. No Stripe, no AdSense. No Optimizely. No cloud. If you wanted to build a website, you had to have engineers and programmers build it for you. You had to have servers to serve the pages. You had to figure out a way to accept credit cards. You had to do your own analytics. Forget a weekend. Try six months.

  And you needed money for that. Money to hire people, to rent space, to buy equipment…money to survive until you could prove your idea had merit, and until you could raise your first serious funding.

  It was kind of a catch-22: You couldn’t prove to your investors that your idea would work unless they gave you money to prove that your idea could work.

  You had to sell them on your idea.

  But before you could accept that first dollar and sell your very first share of stock, you had to put a dollar sign on it. This is called valuation. You come up with a number: What your idea is worth.

  In common parlance, it’s typically a good thing when someone says, Hey, there’s a million-dollar idea!

  But in Silicon Valley, that’s not very much.

  To wit: Netflix is currently worth around $150 billion. Back in 1997, though, Reed and I decided that the intellectual property—the idea for DVD by mail, plus the fact that he and I were the ones working on it—was worth $3 million. That wasn’t a ton—but it seemed like enough. Enough to take seriously, but not so much that no one would want to risk money on it.

  We figured that it would take $2 million to get the company off the ground: $1 million to get the site launched, and another $1 million to run it while raising our next round of funding. We’d need an angel investor. Luckily, both of us knew one: Reed.

  Reed wanted to be our angel investor because, even though he was leaving Silicon Valley for the education world, he wanted a way to stay connected to it. Funding us was his way of keeping his toe in the water. It would allow him to remain a part of the startup culture that he loved so much. Starting and running small companies had given his life order, meaning, and joy, and I think he may have been scared of losing that as he transitioned into the education field. As an angel investor in our company, he’d have a kind of safety net, a tether back to a world he understood and knew how to navigate. It was fear of missing out, pure and simple.

  I decided not to put any money in. For one thing, I’d just had my third child—my son Hunter. And, unlike Reed, I’d be donating a lot of time to the project.

  My risk was my time. His was his money.

  But by not putting any money in at the outset, I’d effectively changed my ownership percentage. To understand why, you need to know a little bit about how startup companies raise money. There’s math involved, but bear with me.

  As I mentioned earlier, Reed and I had assumed that the value of Netflix (which at that point was just two guys and an idea) was $3 million. So to keep the math easy, I decided that to start, there would be six million shares of Netflix stock, each worth fifty cents, and each representing a small fraction of ownership in the company. On day one, there were only two owners of the company—Reed and I—and we split it down the middle. Each of us received three million shares—or 50 percent of Netflix. Now, if nothing had happened since then, and I still owned 50 percent of Netflix, my world would be a little different. As I mentioned, Netflix is now worth about $150 billion. Owning half of that would be a nice piece of change.

  But then comes something called “dilution.”

  Remember, at this point it’s just two guys and an idea. We need to build a website. Hire people. Rent an office. Buy whiteboard markers. (I really like whiteboard markers). So we need money. Reed was willing to give it to us, but he had to receive something of value in return. So what happens is that we sell him stock. We don’t sell him shares that we already have, we create new shares and sell him those. And since we’ve already said that each share is worth fifty cents, in exchange for Reed’s $2 million, we sell him four million shares.

  So now everyone’s happy. We now have a company that is worth $5 million, and its assets include the idea (which we valued at $3 million) and the $2 million of cash. But now the ownership has shifted. I still own my three million shares, but now there are ten million total shares, so my percentage of ownership has changed from 50 percent to 30 percent. At the same time, Reed’s ownership has increased. He now owns seven million shares: the three million of his original shares for the idea, plus the four million shares he received in exchange for his investment.

  So he’s gone from owning 50 percent of the company to 70 percent. We’re now 70/30 partners.

  This didn’t bother me at all. Dilution is a normal part of the startup world. True, my share had decreased from 50 percent to 30 percent—but I’d much rather own 30 percent of a company that has money to pursue its goals than 50 percent of a company with no cash on hand.

  Could I have tried to split the investment with Reed, in order to have stayed 50/50 partners? Sure. That’s called “going pro rata” and it happens all the time. But my pockets weren’t as deep as Reed’s, I had more familial responsibilities, and, unlike him, I’d be spending almost every waking hour of the next few years on our idea. Plus, I thought that putting significant amounts of my own money into the project would limit my capacity for other types of risk-taking. If I stood to lose a million dollars—and not just my job—I’m not sure I ever would have been able to take some of the imaginative leaps that were so crucial in the early going.

  In Silicon Valley, tech talent is the scarcest resource, and an unknown fledgling company can have a hard time attracting top employees. But Reed—thanks to the Pure Atria deal—had clout. Within a few days he’d put us in touch with one of the key players in what would become early Netflix’s eccentric, largely foreign-national ops team: Eric Meyer, a muppetlike Frenchman with a frenetic manner who would eventually become our chief technology officer. Eric had worked with Reed earlier in his career but now held a senior position at KPMG. I knew it would take some convincing to get a talented (and highly paid) software developer like Eric to join our ragtag bunch. So I started as soon as I got his number.

  In the meantime, I needed to come up with something approaching a business plan. Notice that I used the word “approaching.” I never intended to get there. Most business plans—with their exhaustive go-to-market strategies, detailed projections of revenue and expenses, and optimistic forecasts of market share—are a complete waste of time. They become obsolete the minute the business starts and you realize how wildly off the mark you were with all your expectations.

  The truth is that no business plan survives a collision with a real customer. So the trick is to take your idea and set it on a collision course with rea
lity as soon as possible.

  But we still had to figure out where to start, and for that I leaned on Christina. We spent hours at the whiteboard in my office, trying to visualize what an online video store would actually look like. Christina drew every page of the proposed website by hand, sketching out meticulously how every piece of content—the DVD title images, the synopses, the ordering information—would fit. I started looking for office space—or at least for conference rooms where we could meet, once I had a team together. The Best Western down the street from my house in Scotts Valley was my top contender. You could rent the conference room there for $250 a week.

  All of this might seem like it happened fast. And it did—in a matter of weeks, we’d gone from a list of nebulous ideas to a semicoherent plan for moving forward. But here’s the thing about Silicon Valley in the late nineties: everything was fast.

  It hadn’t been slow in the eighties—not exactly. But progress had occurred on a more incremental scale. It was an engineering driven culture, so it all moved at the speed with which things could be built. At Borland International, where I worked in the eighties, the very architecture of the corporate campus—engineers on the top floor, in the window offices, and everyone else on the floors below them—enforced a sense of hierarchy: engineers were on top, and everyone else worked for them. Along with that hierarchy was a certain staidness. Change happened logically, according to plan.

  By the mid-nineties, things had changed. Jeff Bezos’s success at Amazon had shown us that it wasn’t just more powerful hardware or more innovative software that would lead to future progress—it was the internet itself. You could leverage it to sell things. It was the future.

  The internet was not predictable. Its innovations were not centralized on a corporate campus. It was a whole new world.

  Here’s how tangibly—and quickly—things had changed. In 1995, when I was wrapping up my time at Borland, you could actually buy a published book that listed every website in existence. Since there were only about 25,000 sites, that book was less than one hundred pages long. But by March of 1997, when Reed and I were making our brainstorming commutes over the Santa Cruz Mountains, there were about 300,000 websites. By the end of that year, there were a million—and the number of users had grown to a hundred times that number. We weren’t the only ones trying to figure out new ways to monetize the internet. There were thousands of people like us looking for the right angle, the right product, the right way to take advantage of a brand-new medium.

  I’ve heard people call the mid- to late-nineties in Silicon Valley “the era of irrational exuberance.” And I agree about the exuberance part. Who wouldn’t be exuberant about the advent of one of the most revolutionary, game-changing technologies in the history of our species?

  But irrational? Not quite. The excitement we felt at the dawn of the internet era was completely rational. We were on the edge of an open green field—unplowed, unplanted. Talk to enough entrepreneurs and engineers about the mid-to-late nineties, and what they’ll describe to you sounds like something straight out of the journals of Lewis and Clark. We all felt like pioneers on the eve of a great expedition. There was enough land for everyone.

  4.

  Getting the Band Together

  (July 1997: nine months before launch)

  A WEEK AFTER WE mailed the CD, I found myself at the head of an eight-top at the Cupertino Hobee’s, halfway through a massive BLT. Half-eaten burgers and crinkle-cut fries littered the table, pushed aside to make room for binders, notebooks, and coffee cups. We were really doing it.

  For the uninitiated, Hobee’s isn’t exactly fine dining. It’s basically a diner: tables molded to the wall, laminated menus with pictures of food on them and no stains, because they go into the dishwasher at the end of every shift. A cup of coffee costs two dollars and it’s endlessly refillable.

  We didn’t choose Hobee’s because the food was good. And we weren’t meeting at Hobee’s in an effort to keep our idea secret. In fact, secrecy was the least of our concerns. I’d realized by then that telling people about my idea was a good thing. The more people I told my idea to, the more I received good feedback, and the more I learned about previous failed efforts. Telling people helped me refine the idea—and it usually made people want to join the party.

  So why Hobee’s? Location, location, location. We used a compass to draw equal-size circles around Christina’s house in Foster City and my house in Scotts Valley. When you intersected those two circles, Stevens Creek Boulevard in Cupertino was in the exact center. No more than a thirty-minute drive for anyone.

  Who was anyone? Christina, Te, and I, of course. Eric Meyer, our provisional CTO, looking at his overly foamy cappuccino with Gallic disdain. Boris and Vita Droutman, a married Ukrainian couple with heavy accents and, Eric assured us, a genius for coding. And Reed, on the rare occasions he could get away from the Pure Atria offices.

  We had to meet at Hobee’s because we were in a weird, in-between place: moving toward being a real company, but without any kind of office. Or the money to rent one. Christina, Te, and I were still employed at Pure Atria, and it wouldn’t do to have people coming in and out of our offices there all day, working for a different company. So we stole time after-hours, or during lunch breaks, heading to Hobee’s for two-hour meetings to discuss our company-to-be: what we were going to do, how we were going to do it, and when we could start.

  Christina and Te did hours of market research, and over their Cobb salads would present it to us. “In the past week, I’ve gone to fifteen video stores, and here’s what I learned,” Te would say, before Christina pulled out her preliminary drawings of what she thought the site might look like. Boris and Vita would huddle with Eric, talking about tech specifics in a language so advanced I really understood only every other word. I was usually doing about three things at once. While my body was at the table, attending to these conversations, my brain was often elsewhere, trying to figure out how to convince a new person to join our team, or what we should call ourselves, or where we’d land, once we had our funding finalized. We couldn’t stay at Hobee’s forever.

  I also needed a CFO, and I had my eye on a guy I knew from Borland named Duane Mensinger. He fit the profile exactly: professional, with a work history that included close to a decade at Price Waterhouse. In casual California, where shorts and flip-flops were the norm, he was never seen in anything except a button-down shirt. But the very qualities that attracted me to Duane—he was careful, organized, and risk-averse—were the ones that kept him from committing to becoming part of our merry little group of outsiders. While he repeatedly and ever so politely told me no, he kept his iron in the fire, agreeing to help us build our financial models and acting as a kind of “rent-a-CFO.”

  I had the opposite problem with a man named Jim Cook—who ended up as one of the most important members of the Netflix team. He was a friend of Christina’s, a burly guy who had worked in finance for years at Intuit and always had a shit-eating grin on his face. I liked that about him—it’s good to have optimism in the startup world. The problem, however, was that he desperately wanted to be the CFO. He certainly looked the part. Jim dressed like a banker: pressed pants, crisply ironed dress shirts, every last one of them light blue. He was organized, detail-oriented, and efficient—and unlike Duane, he was accustomed to startup risk-taking. Like the rest of us, he actually enjoyed it. I thought that made him perfect to run operations—to figure out just how we were going to buy, store, and ship DVDs.

  But he didn’t agree. It took me a few meetings before I realized that his big grin was more than just optimism—it was a negotiating tactic. My strategy, when I’m not getting what I want in a negotiation, is to sigh and display my weary sadness, to make the other party feel like a child who has disappointed his parents. You know the drill: I’m not mad, I’m just disappointed. Jim’s was to just broadcast a huge creepy grin at me. It was unnerving.

  But it didn’t work. Jim would sign on as our director of fina
nce and operations in October. In the end, I realized that he was more interested in the finance title than he was in the actual job. I’m usually wary of title inflation—although it’s something that seems like it costs you nothing to give, it actually is far more expensive than it seems, since it causes a cascading series of overpromotions. For just this reason, I had already decided that no one would get a VP title—at least at first. Instead, they would all be directors, and their titles would reflect what they actually did, not what they wanted to do. But in Jim’s case, a little rule-breaking was unavoidable. He was too valuable to lose over a job title, so I reluctantly agreed to add the finance piece, while impressing upon him that with Duane on board—albeit in a temporary way—the real place we needed him at the start would be in operations. CFO would come. He would just have to be patient.

  In the meantime, I had to find a place for Jim—and all the rest of us—to work. We needed an office. I had strong feelings about being a Santa Cruz company—of bucking the prevailing norms of Silicon Valley and not moving to a cookie-cutter office park in Sunnyvale or San Jose. Santa Cruz spoke to me. It’s a beach town, a surf town. A whiff of the sixties still clings to it. There are probably more Volkswagen vans than there are people. Its prevailing ethos, as a city, is the opposite of Silicon Valley’s “growth at all costs” model. People in Santa Cruz are typically against development. They’ve opposed widening the roads. They don’t want it to grow.

  Growth is God, over the Santa Cruz mountains. But in Santa Cruz, it’s vulgar.

  I wanted some of Santa Cruz’s laid-back ethos for my company. I didn’t want to attract just the same group of ambitious young tech workers from over the hill. I wanted freethinkers, people who were slightly outside the box. I wanted things to be different.

  I wanted life balance—for me and for my co-workers. I wanted Santa Cruz’s access to trails and waves and a more relaxed way of life, and I didn’t want to have to spend two hours every day commuting to Palo Alto. If I was going to start my own company, I wanted it to seamlessly integrate with my life. I wanted my kids to be able to come by the office for lunch, and I wanted to be able to drive home for dinner with them without spending hours inching along in a conga line of cars.