February 1, 2007, 12:00 AM

Light Bulb Moment

A $40 late fee begets an idea by Netflix CEO Reed Hastings worth $682.2 million.

The combination of a $40 late fee on an overdue rental at the local video store and Big Money stashed away following the sale of a software company doesn’t sound like a typical genesis of a $682.2 million company. But such was the beginning of Netflix Inc. To that combination, Reed Hastings, founder and CEO of the online video rental giant, added something more: the pursuit of process efficiency that drives most software engineers, and, underlying that, a mind sparked to creativity when faced with a challenge.

The story of how Hastings got the idea for Netflix after an experience at his local video store might suggest it was a love of film that ushered him into the movie rental business. But while the 45-year-old Hastings enjoys a good movie as much as the next guy, what stayed with him after forking over the hefty late fee was what struck him as the inefficiency of the whole video rental system and the realization that here was a process ripe for re-engineering.

“It just bugged me,” he says. “It was like a loose tooth you can’t stop playing with with your tongue.” Casting about for a ­better way, Hastings realized that the ­pricing structure at the gym where he worked out provided a model of sorts. For a set monthly fee, he could use the gym as much or as little as he wanted. “I realized you could do the same thing with video ­rentals-charge a flat fee and take away all the late fees,” he says. And that is the idea at the core of Netflix.

The continuous and gradual mental noodling that spawned the working model for Netflix, launched in 1997, is representative of how Hastings’ mind works, ­according to those who know him. “Reed is very, very smart. But there are a lot of smart people out there who still can’t take a business, figure out the business model and grow it,” says Bob Pisano, president of the Motion Picture Association of America and a former member of Netflix’s board. “What Reed has got on top of that is the ability to constantly analyze a problem and readjust his thinking.”

Young entrepreneur

DVDs, let alone consumer adoption of the Internet, weren’t on the horizon when the Boston-born Hastings started professional life. A 1983 graduate of Bowdoin College, Hastings did a tour of duty with the U.S. Peace Corps as a high school math teacher in Swaziland. The interest in mathematics segued into a fascination with the then-emerging field of artificial intelligence, and by 1988 he had earned a master’s degree in it from Stanford University.

An early job at a California research laboratory led to a position at a new San Francisco Bay-area company, Coherent Thought, a vendor of application-specific expert systems. Coherent later went bankrupt, providing Hastings with a valuable lesson on just how tough it can be to make a start-up fly. But that didn’t stop him from launching his own start-up, Pure Software, in 1991. Funding came from family and friends for the first year; after positive product reviews, venture capitalists came in for the second year and beyond.

Pure’s product was bug-busting software that found errors in other software to circumvent computer and system crashes. Given the computer’s movement into the center of corporate business operations, it was an idea whose time had come. By 1997, at the time of its acquisition by Rational Software-which has since been acquired by IBM Corp.-Pure had become one of the 50 largest software companies in the world.

Hastings’ exit from the company led him back to his roots in education, this time as an advocate for the successful California Proposition 39, which made it easier for communities to pass school bonds. From 2000 to 2004, he was president of the California State Board of Education.

Civic interests aside, Hastings already had the experience of building one successful enterprise from scratch, and he had the cash realized from the $750 million sale of Pure. Put an experienced entrepreneur intrigued by a business problem together with the money to fund a first pass at it, and a Netflix or something like it is almost bound to happen. When Hastings eventually added to the subscription pricing model a rotation system that would let consumers have as many DVD rentals as they wanted per month, but only a set number at a time, he didn’t have to sell investors on the concept to get it off the ground.

“I was fortunate enough to have done well financially from the first company,” Hastings says. “So I self-funded Netflix when it started.” The company quickly garnered results that caught the eyes of venture capitalists. It ultimately raised more than $100 million between 1997 and 2000, spending all of it and getting down to $5 million in cash before breaking even in 2003. Netflix has been cash-flow positive ever since.

That’s not to say the company can rest easy. It faced a threat from a formidable potential foe in 2002 when Wal-Mart Stores Inc. got into the online DVD rental business. Wal-Mart’s strategy was to undercut Netflix on the monthly subscription fee, but Wal-Mart didn’t have the broad base of geographically dispersed, dedicated distribution centers that Netflix already had started building to make two-day shipping possible.

Wal comes tumbling down

When Wal-Mart later withdrew from DVD rentals, Hastings figured it was because Wal-Mart saw a better opportunity in selling them. Others construed it as a “if you can’t beat ‘em, join ‘em” scenario that wound up giving a big lift to Netflix when Walmart.com handed off its DVD rental business to Netflix in 2005. As part of the deal, Netflix agreed to promote Wal-Mart’s DVD sales online and in mailers to its then 3 million subscribers.

Netflix also has been ­battling it out with rival store-based Blockbuster-which launched its own subscription-based online DVD rental service in 2004-and not just in the marketplace. Legal action as Netflix is suing Blockbuster for alleged patent violation in the operation of Blockbuster online on the one hand and Blockbuster pursuing antitrust claims against Netflix on the other are ongoing in U.S. District Court.

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