Light Bulb Moment

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.

IRCE 2008 Conference Multi-Media CD-ROM

Others, too, have entered the fray in the marketplace. Amazon, for example, which already had been renting DVDs online in the United Kingdom, last year acquired CustomFlix Labs Inc., a company that digitizes limited-run and ­classic movies and puts them on discs, on demand, for customers.

One way Netflix seeks to differentiate itself from the others is the use of a powerful, internally developed recommendation engine that guides individual customers toward films in its 70,000-title bank that they might like to rent. Recommendations are based on collaborative filtering of community behavior. Hastings uses the engine himself, recently finding—and liking—“Koyla,” a Czech film that wraps a parable about political change around the characters’ personal story. Outside his usual favorite genre of historical drama, Hastings says he might have written the film off as “an Eastern European chick film,” were it not for the Netflix recommendation.

But Amazon knows a thing or two about collaborative ­filtering and personalization, too. Increasingly, that could center the competition between any format of movie offering from Netflix or Amazon on who’s got the ­better engine—and Netflix is getting ready. In October the company announced the $1 million Netflix Prize, which will go to the first person or team that can develop a new personalization engine that will improve the accuracy of its movie recommendations by at least 10%.

In December Hastings said that of the entries received from more than 10,000 teams and individuals, “already more than 20 are better than Netflix, and they keep getting better. The great news is that we will incorporate all of their improvements into our service so everyone will get the benefit of their hard work.” If no one wins the grand prize in 2006, Netflix will award a $50,000 progress prize for the most significant advancement each year until someone grabs the big prize.

Video on demand

One question Hastings probably is asked more than any other these days is about the future of video downloads or video on demand; and specifically, about Netflix’s strategy. Hastings has said he expects Netflix to position itself at the forefront of that trend, and that the company invested as much as $10 million in a download initiative last year and will invest another $40 million-plus this year.

In discussing when—not if—consumers will embrace movie downloads, Hastings cites the barriers to be overcome before downloads overtake DVDs in the rental marketplace. For instance, there’s the problem of getting downloads from the computer onto the TV screen. Soaring sales of ever-larger flat screen televisions suggest consumers aren’t going to cluster around the PC to watch a movie—they want to see it in their den or home theater.

In January Netflix took a step toward electronic delivery of films by debuting a new instant-viewing feature that delivers a selection of movies to subscribers’ PC screens via live Internet feeds. They’re not downloads, and they aren’t delivered to a TV screen, but they do bring Netflix closer to what it says is its eventual goal of getting movies to every Internet-enabled screen—including television screens.

Others are launching other forms of electronic delivery. Netflix’s announcement trailed by one week the launch of Apple TV, a device that connects to most widescreen TVs, enabling viewers to wirelessly pull content such as downloaded films from their PC into their home entertainment systems and onto their TV screens from up to 30 feet away.

But an even bigger impediment than getting the movie from the PC to the TV screen still hinders the widespread use of downloads among consumers, and that’s movie studio economics. The studios make more money licensing movie rights for other uses than for direct downloading to consumers. That’s one of the reasons that those who are offering movie downloads don’t yet have significant content to offer. Movielink, for example, an online film downloading service owned by the studios, offers titles representing only about 3% of Netflix’s total DVD catalog.

So while it doesn’t pay to rush movie downloads to a mainstream market not yet prepared for them, it wouldn’t pay to be late to the party, either, an equation Hastings must balance carefully while Netflix is deeply invested in DVD distribution. “Studios want to find a way to make more money, not less,” he says. “Consumers want to find a way to pay less money, not more. To succeed, both the consumers and the studios have to be happy, and that’s a hard one to figure out.”

While no one has that answer yet, Hastings already has demonstrated in his career that sinking his teeth into a knotty problem, shaking it around and eventually worrying a solution out of it is his specialty—a trait that could one day help place Netflix at the forefront of the almost inevitable technology changeover.

“One characteristic Reed has is that he’s able to take on bits of information, store them away like a computer, and call on them with almost total recall weeks, months, years later, and assimilate them into a pattern,” says Pisano of the Motion Picture Association of America. “Many executives decide on a business model and then never change it because they are not able to understand that things change. Or that you were wrong in the first place, and therefore you have to readjust. Reed is constantly readjusting.”