Acquired - Season 3, Episode 8: Netflix (Part 1)

Episode Date: November 12, 2018

In a world ravaged by late fees and lack of rewinding, one man two men from a sleepy California beach town make a stand against tyranny, daringly dethrone an evil empire and… oh who are we kidding, they just copied Amazon’s business plan for books and applied it to movie rentals. But as always there is much more to the story than that! We dive into the fascinating, true, and oft-untold history of Netflix in our first two-part special on Acquired. Part 1 covers Netflix’s original DVD rental business from founding to 2009, and next time on Part 2 we’ll cover the (rocky) transition to streaming from 2010 to present. Buckle up for a wild ride!Sponsors:ServiceNow: https://bit.ly/acqsnaiagentsHuntress: https://bit.ly/acqhuntressVanta: https://bit.ly/acquiredvantaMore Acquired!:Get email updates with hints on next episode and follow-ups from recent episodesJoin the SlackSubscribe to ACQ2Merch Store!Links: Netflix’s original logoCarve Outs:Ben: The Good Place on… Netflix!David:  The Broken Earth Series by N. K. Jemisin

Yep. It's 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 biggest complaint is the lack of SCSI. 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 16 years ago

and it was founded 21 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.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, you know, we when we first started researching this, 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. We're going to 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 $5 a month or go to kimberlite.fm slash acquired. That's K-I-M-B-E-R-L-I-T-E dot fm 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. Okay, listeners, now is a great time to tell you about longtime friend of the show, ServiceNow. Yes, as you know, ServiceNow is the AI platform for business transformation, and they have some new news to share. ServiceNow is introducing AI agents. So only the ServiceNow platform puts AI agents to work across every corner of your business. Yep. And as you know from listening to us all year, ServiceNow is pretty remarkable about

embracing the latest AI developments and building them into products for their customers. AI agents are the next phase of this. So what are AI agents? AI agents can think, learn, solve problems, and make decisions autonomously. They work on behalf of your teams, elevating their productivity and potential. And while you get incredible productivity enhancements, you also get to stay in full control. Yep. With ServiceNow, AI agents proactively solve challenges from IT to HR, customer service, software development, you name it. These agents collaborate, they learn from each other, and they continuously improve, handling the busy work across your business so that your teams can

actually focus on what truly matters. Ultimately, ServiceNow and Agentech AI is the way to deploy AI across every corner of your enterprise. They boost productivity for employees, enrich customer experiences, and make work better for everyone. Yep. So learn how you can put AI agents to work for your people by clicking the link in the show notes or going to servicenow.com slash AI dash agents. All right, David, you're ready to take us in with the acquisition, I suppose the IPO history and facts. Well, there will be lots of acquisition offers back and forth as we go here but there were 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 netflix yeah this is really fun when we were discussing what

episode to do uh for this one we were like okay we're getting kind of towards the end of season three we want to do like 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 going to cover Netflix from founding through about 2009 on this episode. Part two, next time we're going to go 2010 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 1997 a successful former enterprise software guy from santa cruz of, uh, is fed up with movie rental late fees. Uh, these are the VHS days still, and kind of 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 reed hastings this is a true statement the illustrious ceo of netflix the illustrious ceo of netflix is i texted ben when we started researching this and reading netflix the parallels to Tesla here are like unreal.

It's pretty awesome. So Mark Randolph, the reason that is true is he was the CEO of Netflix for the first year while Reed Hastings was finishing up graduate school at Stanford. Yes, but really he was the founder and CEO of Netflix. I 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 Looker, I believe, a data analytics tool. And Looker 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 official founding story, the lore, we're going to give you

that, then we're going to tell you the true story. So official story, Reed 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 how it can just not just change whether it was true or not. We've seen this many times. So 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 going to quote from Reed Hastings saying in print to Fortune magazine in 2009, quote,

the genesis of Netflix came in 1997 when I got this late fee about $40 for Apollo 13. Remember Apollo 13? So good. Great film. 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 24 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 13 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 because 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 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 netflix so for those of you who are you will intimately understand this 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 1997. 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, formerly Pure Software, in Sunnyvale, California. Which merged with Atria. Which merged with Atria, yeah. So what was this company? It was a publicly traded company. It made bug detection software for developers. Tools company, Ben.

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 job for three years and then decided i'm going to start a company david i don't know if you're are you going to touch on his his background before starting pure not really not really so go for it all right 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 second job was starting Pure. And in between, he did a master's in CS at Stanford. I think he went to Bowdoin undergrad on the East Coast. But yeah, 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 simple notion that he had we got out to the Valley. So he's running Pure. It's going well.

It was sort of predicated on a simple notion that he had around building a better debugger. He's starting to amass a large team. You know, they're taking all this money. They're getting ready to go public. He tells the board, hey, I want to not be CEO of this company. 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 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 doing in the day and age, which was firing CEOs as soon as they humanly could or firing founders. Okay. So as Ben alluded to pure Atria at this point, it's publicly traded. It's basically a rollup.

They'd acquired Atria. They'd 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 small companies that pure Atria had acquired. And after the acquisition, he read 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, which is the biggest competitor in the space. They've just announced they're going to merge public to public merger. It is actually going to be the largest merger in Silicon Valley history at that point in 1997, valued at just under a billion dollars. Yeah, cute. Cute, just under a billion dollars. And Reed Hastings is finally going to get his wish. He's going to be fired as CEO, not fired, but he's going to be redundant. He's not going to stay with the company. Neither is Randolph. And it's interesting to note here,

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 a lot of these other companies, went from being a heat-filled, everybody-wants- 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 Yeah, and that will come back into play. Reid is about to become hugely wealthy. He's still very young, hugely wealthy,

and his plan is to basically ride off into the sunset. He's reapplied to Stanford, this time to do the graduate program in education, which is a fantastic program. By the way, a lot of people do GSB and the education master's jointly. Reid's going to go do this one year grab 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, 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 going to become important. Santa Cruz is a sleepy little university slash beach slash surfer town over the Santa Cruz mountains, which separate Silicon Valley. 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 as 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 inc dog food yeah anyway um he starts the shell company they're spitballing stuff he starts thinking about as ben alluded to he'd worked at mac world 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 compu serve customer acquisition techniques that i think we've referred to in the past of uh just mailing out tons and tons of cds to potential customers i mean how many aol cds 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 95 to 99 was just saturated with aol coasters somewhere now well the important thing that i want to say about randolph here is basically his background but you know before puratria he's a publishing guy he knows the publishing industry inside and out and kind of stacked onatria, he's a publishing guy. He knows the publishing industry inside and out, and kind of 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 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 getting launched. It's in the movie studios and electronics manufacturers are just rolling it DVD. It's just, just getting launched. It's in the movie studios and electronics manufacturers are just rolling it out. It's being launched in a few test markets. And of course, DVDs come on optical discs that are the same form factor as a CD. And so Randolph's

like, Oh, well, maybe we can mail these things. 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 you know day or two when they're meeting to commute together reed's got the mail is it gonna come is it gonna come is it gonna come 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 sort of riding it the whole way.

Like, they were betting that DVD was going to succeed because 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, like you gotta store them and catalog 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 think i'm gonna dabble in angel investing um i'll fund this company. So just like Elon did with Tesla, Reed leads the first round of funding in Kibble Inc., which in a little bit becomes Netflix. Reed invests $2 million.

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 Scotts 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 is now bigger than box office for uh for film and television um i guess mostly film at this point it's enormous and the rental segment so there's both sales and rental of home video the rental segment is completely dominated by blockbuster there's hollywood video

and a few others but like blockbuster is that the 800 pound gorilla i want to quote the s1 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 going to be in your seed pitch deck. It's going to be in your A pitch deck. And the second paragraph of the S1 and when Netflix goes public, the first paragraph describes what they do. The second paragraph is, in 2001, domestic consumers spent more than 32 billion dollars on in-home filmed entertainment representing approximately 80 percent of filmed entertainment blah blah blah goes on to talk about exactly what david just said that the the largest portion is rental i was reading the s1 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 your time? Then how are you differentiated? Yeah, like just it never ends. The more things change, the more they stay the same. Quick aside, because I think there's an important point here. This whole business of movie rentals is in the first iteration of Netflix's business and the blockbuster business is enabled by a Supreme Court ruling around copyright law of what's called the first sale doctrine. 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 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 bezos always credits the uh infrastructure that was laid before him that allowed the company to exist, the internet, UPS, et cetera.

Like, you know, this wouldn't have been possible if what they had to do was go and lobby and get laws changed at the outset. The infrastructure had been laid for them. Go vote. It's important. Hopefully you already voted in these elections. Yeah. I assumed they had to pay some form of royalty back to the content

holder every time they rented it i mean 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 15 to 18 or whatever for a movie and then you run it out for what like three three, $3 and you run it 50 times or something. It's an awesome business. It's the same business as scooters today. You know, you buy a scooter for 300 bucks, you rent it for a couple bucks per ride and you do thousands of rides and that's a good business. 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 going to 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. 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 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 going to buy. And so it's kind of just like Stitch Fix like that we saw there, like getting that early industry DNA on the team, like really has a big impact together. They and they'd hired a couple of people from Pure, a couple of folks that they'd worked with in the marketing department there. They all said 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 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 awesomely awful it was 97 to 2000 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's got this little like swooshy thing and it's very late 90s yeah so it's purple it's bad it's bad um okay netflix so what do they do this is this is brilliant and i think this is driven by by mitch low 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 dvd product forums and they just start talking about netflix there and like people because these things are like 600 bucks like getting a dvd product forums and they just start talking about netflix there and like people because these things are like 600 bucks like getting a dvd player was like uh oh i'm buying like over a thousand bucks at this point in 1997 dollars so like the people who are buying these things are super techie super early adopters like the perfect market to adopt netflix and give you know feedback here isn't it 640 by 480 like it's there's not a lot of pixels like yeah i think that i think it might even be less like you know it's for show research here we didn't even go back and watch dvds like i don't i don't have a dvd

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 yeah you know me neither huh well wait for stay tuned for part two um so they officially launched the product in april 1998 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 dvd you just pay a certain amount and then you can either keep two or three depending on 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. Well, that part of the business is going to come up again 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 u.s i forget which ones are u.s 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 u.s consumers um so they're pushing it hard best buy is 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 heck like it doesn't get any better than that uh and this was a big part of their customer acquisition for

many many years and it works like amazingly, that the only downside is they're giving away a free month of Netflix as the promotion that ends up coming back to bite them in terms of that cost them a lot of money, 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 going to use that. Like, you know, we're'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 could how could they not believe that this was going to 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 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 divx were battling it out against one another and it wasn't clear in the beginning who was gonna win whoa i forgot about divx yeah divx um that's like way lesser known than even like betamax or hd dvd or any of these alternatives it was the betamax of the the optical disc era. So Blockbuster was kind of waiting on the sidelines to see what would happen before they made the big bet and threw their weight behind it. Netflix bet the company on DVD over DivX. I don't know why.

Maybe they just were like, oh, DVD, we'll go with that. But fortunately, it worked. So that's... DivX ended up becoming like a digital like a not stream but like it was like a file like a file encoder format and i used to have like a divx player on my mac that i could like play divx files if i was downloading them from the back of a truck somewhere and oh the early 2000s 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 shipping. The first four months after launch, they do 20,000 rentals. They're already at a million dollar revenue run rate. Like that's super impressive. Even today, like startup, you launch, you're 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 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 officially 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 a hard place because 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 going to 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 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 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 going to 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. Softcore pornography becomes huge,

as with all video formats. The aphorism that pornography drives innovation, also true here. It's going to come back in a sec. So they raise a Series A. There is a $6 million Series A from IVP in August 1998 to finance all of this. Reed is still finishing up at Stanford. He's just the investor. The angel investor is just on the board. He's not super involved. Uh, once he finishes his masters, he gets into, you know, education philanthropy as he wanted to. He also starts this thing called tech net, 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 1999 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 going to go spend some more time there. He basically just shows up and announces like, OK, now I'm going to be co-CEO with Randolph here.

And Randolph is apparently not super happy about this. But like, you know know the company's growing so and reed is great so like everybody kind of gets along and they initially divvied up that randolph is going to be in charge of marketing and content acquisition and reed is going to be in charge of engineering and ops this is where reed really starts building like a world-class technical team technical and ops team 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 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 data engineering yep and remember they're still in santa cruz in scotts 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 going to go bankrupt. So the first thing that the board and read a mark think is like, 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 than the inspiration for the company, Jeff Bezos. So the two of them fly up to Seattle. They meet with Bezos. This is 1998 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.

Bezos is like, I'll give you $12 million 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 netflix is like come on like no we're not going to sell the company but how about we do 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 our subscription model um how about we give you that so whenever anybody on any netflix customers want to buy dvds we'll just kick them over to amazon to buy dvds 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 yes toys r us and target was like yeah yeah oh man it's a crazy imagining amazon today doing some gigantic co-branded corner of their their store like that serious well especially given what we'll see in part two with amazon and video so in return amazon is going to advertise netflix on the home page remember this is the era of portals which is 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 going to take over as the only CEO. I'm going to do this fundraise.

I need to be the face of the company. Come on, investors at this point need to bet that I'm going to do it again. Yep. He also, he's like, and we got to move out of Santa Cruz. We're going to 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 30 plus minutes south of Palo Alto and Mountain View, I would say. And Netflix is still there today. And lots of people, especially as the company's grown, now live in San Francisco and work

in Los Gatos and spend two hours a day on 101 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 started in its first revision, but the Netflix culture is extremely unique. In the early days, 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 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 Hastings doesn't ever refer to it as a family. It's not welcome to the family. The 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 it's a really high performing team. And to the degree that in a family you can sort of love someone, even if they're not 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 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 A player. And they say, they take the burden on this and say, we were extremely generous with severance, but we're extremely opinionated that 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 hastings has released the deck on slideshare and i think it might be like the number one viewed uh deck on slideshare many years ago it was released on slideshare and it's still 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 because it's a great recruiting tool i mean for the right set of

people like that's why they did it yeah it's moth to a flame yeah yeah yeah so one of the things that makes them different you see reed's personal history and and shaping reflected in this culture like as all companies right or like like my partner riley at wave is he always says like company cultures are like reflections of pure reflections of the founder personalities. Reid is a guy who was in ROTC, was going to join the Marines, and then instead did the Peace Corps, and then went to Silicon Valley and became an engineer, and then a CEO, and then a philanthropist. It's just all this dichotomy 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 dot-com crash, they're like, oh, Reed Hastings, you're raising? How much money can I give you? He raises, within a few months, raises $100 million.

Or rephrased from 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 check size is right he raises a hundred million dollars mostly from tcv and we'll see tcv ends up being a enormous shareholder in Netflix and IPO and several other firms. One of the first hires he makes after becoming full CEO of the company is acquired superhero who has showed up in at least one other episode. Spotify episode. Probably many more. Barry McCarthy, who he hires as CFO of Netflix. And Barry becomes critical to Netflix's success

and then does his short detour at Klinkle before going to Spotify. Yeah, fast forward through that, or DVD skip through that. So Barry's fame from folks who have listened to the Spotify episode is that he's the guy who sort of conceived of and then executed the plan for the direct listing, 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 hired Tom Dillon from Seagate to run Ops for the company. Remember, Ops 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 that drives retention but most importantly that drives word of mouth uh and organic distribution like when you click rent magical experience and you get remember this is yeah 1998 99 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 how could it not be you know actually instant. But I am remembering, I'm trying to think what year it was, probably 2000. It was the summer of 2008. Cause I was doing my internship in North Carolina for Cisco and my roommates and I did a Netflix plan for our apartment. Cause none of us were 21 yet. And so we were like, 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 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 re and, and then the rest of the company, of the company, of course, but they figured this out and they realized 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 going to build them in big cities and geographical density. They start like, they get really analytical about it. Like where's our customer base? Where's it growing? Where are word of mouth hot spots let's build distribution centers close to them and get these dvds 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 manage your netflix queue 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 subscribed way late. I'm not I don't watch a ton of movies. So it was I was not the target market. I remember being obsessed and actually comparing my queue with friends. There 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 tried 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 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 queue that i was constantly adjusting of like which movies were going to 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 and 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 one real quick funny aside i mentioned um pornography

being a big part of netflix in the early days reed in 2000 he gets appointed to the california board of education uh he's like um we need to get out of this pornography thing. So let's just let's just 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. OK, it's 2000. Growth is great. Everybody's high flying, high fiving.

They got a team, you know, built at the company. They filed to go public. McCarthy's going to take them public. They have 120,000 subscribers. They're shipping 800,000 DVDs a month. Everything is great. But then the dot-com crash happens 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 $100 million 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 you know we want to sell it for 50 million 50 this company's raised like 150 million at this point like imagine if this transaction had happened blockbusters like you seem kind of desperate i don't think so we're just gonna crush you unreal absolutely unreal totally unreal so for the companies that made it through the dot-com burst you look at amazon you look at net, you're like, wow, they were really smart, really good capital allocators. We're super nimble. We're able to make it through this. Like Netflix tried to get out.

They were like, look, we'll just cut our losses and go be part of Blockbuster. Totally. And again, Blockbuster are not idiots. They're really not. Like they, at this point, see DVDs 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 like we could spend 50 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 and 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 the website was terrible there's actually a really good i recommend uh so friend of the show uh caro over at wondry they did an episode um or a little series called business wars what was about netflix versus 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 terrible the website is. And they can't even like. They got Accenture to build it.

They didn't hire their own engineers and like. But they overcome it. They actually make it good. 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 sec. 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. I guess we're going to have to soldier through. So they do, this is, we're going to say these things, but like, I want everybody to like really think about this. They do a 40% layoff, a 40% riff of the company. Four out of 10 people, they lay off. Remember, just a couple months ago, they were going to go public and everyone was high fiving. Having lived through my first two years in the working world, the 2008 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, 10 years. Imagine that like 40% of your-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 an immediate company meeting and says 40 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 because you're gonna go bankrupt or you need to cut the burn this is wartime you know and this was also is interesting uh reading, reading that Netflix book,

the way that Barry McCarthy sort of was looking at this as 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 IPO-ing with $15 million in the bank. Um, so they definitely needed that, that mezzanine round that they thought was just going to be to, uh, let those investors buy a little extra equity, but it was really it was really about what story were they going to go tell the street when they were able to IPO in 2002. Yeah. And I think they weren't quite profitable when they IPO'd, but they were on track to be profitable the next year. And they needed to show that even if they were a very lean organization and they needed to be in this dot-com burst era that they could still execute their business yep 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 10 then let's cut another 10 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 that in this episode and then there's 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 in this episode. And then there's a third example that we're going to save for the second part of this Netflix set. But Reed Hastings and Netflix management are awesome at executing these like, we made a decision, we're going to 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 netflix indeed well okay uh the next year may 2002 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 82 and a half million dollars in their ipo at a market cap of just over 300 million dollars so they sell over a quarter of the company in the ipo oh i mean like can you imagine that these days it's like seven to ten percent like you you know, like, well, and it's not, it's, they're not IPO-ing for $300 million. Yeah, 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. Yeah. Seriously. Um, but the business is capitalized and then, you know, they have no debt. They, they, they don't need to raise any more money. And they eventually do take on debt, but I believe not until the streaming era. I think they did a tiny secondary the next month and just sold a little bit more in sort of an additional stock offering.

But yeah, to your point, nothing meaningful for a while. Yeah, they're fully capitalized. So remember Randolph, the original CEO, and Lowe, the guy who was running the video stores in Marin. Now that the IPOs happened, they're like, okay, great, we're going to go focus on new things like initiatives within the company now. And they start testing kiosks, Netflix kiosks, that they're going to put in grocery stores.

And they're like, this is going to 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 instant well maybe it is but eventually mccarthy and everybody they're just like guys we just did a 40 riff we finally got public we got to stay focused 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.

Lowe and Randolph are so obsessed with this idea. The two of them, so they've convinced a 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 startupely startupy they decide it's not worth our investment in figuring out how to actually build a vending machine that's going to 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 smith's 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 things that don't scale i know low and

randolph actually got 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 awesome it is awesome uh as we will see. 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 Lowe went and talked to the CEO of McDonald's and was basically like brokering a deal. It was like then he came back to this guy freaking loved it. McDonald's was like, we want to roll this out at all of our, you know, 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 going to be in McDonald's when they're waiting in line like that. No, absolutely not. And so part of killing it was like, like look we don't have the head count for this we don't 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 low they're demoralized netflix has changed so much randolph you know he started this thing he was ceo like you know it's it's time for us to go they go randolph gets full-time into

investing and as we talked about chubbies and and and looker and all that lo 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 red box coin star 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 like that. But Redbox is now part of that private equity family. Yeah, crazy. All right, listeners, our next sponsor is a new friend of the show, Huntress. Huntress is one of the fastest growing and most loved cybersecurity companies today. It's purpose built for small to midsize businesses and provides enterprise grade security with the technology, services and expertise needed to protect you. They offer a revolutionary approach to managed cybersecurity that isn't only about tech, it's about real people providing real defense around the clock. So, how does it work?

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and the industry leader in managed detection and response again this summer. Yep. So if you want cutting edge cybersecurity solutions backed by a 24-7 team of experts who monitor, investigate, and respond to threats with unmatched precision, head on over to huntress.com slash acquired or click the link in the show notes. Our huge thanks to Huntress. Okay, so back to Netflix. We're now in March 2003. 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 plane. I really want to go be the CEO of my own company. I'm going to leave by the end of the year and do that. But I want to give everybody plenty of notice, want to give the street notice. So he announces that almost immediately afterwards, Blockbuster fully launches. They've been testing. They fully launched 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 of 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 had to do Netflix. Blockbuster gets 50% of new signups. So of new people coming into the market, which is where the vast majority of the market is still coming in. Blockbuster takes 50% share immediately. Yeah. And if you think about that, the timing on this, so when, when Netflix IPO, they had 500,000 subscribers. It's an not that big of a number on the number of movies. It was 11,500 movies, as they say in their S1. So it's now 2003. Netflix is barely profitable. They just turned their first quarter profit.

Blockbuster launches this. This is exactly at 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 200 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 launch it exactly this time is like kneecap yeah this this uh million subscribers that they have up from 500 000 at ipo is you know there's uh what 200 million households in the u.s 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 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 announced this they're like we got to be honest about this with the street they announced this on their q3 analyst call that they think Amazon is coming. They're going to get ready for it. And McCarthy says, I'm not leaving. I'm staying. I'm going to 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 fight, which is just awesome. What a hero. And, uh, uh,

and he literally like swashbuckling comes rides back in in anticipation not of blockbuster not in reaction to blockbuster but in anticipation of amazon coming in because they think amazon's gonna follow the amazon playbook and just undercut everybody on price netflix cuts their subscription price by almost 20 for the first time it's like sub $20 for the big plan. Yep. Unfortunately, this turns into a full on disaster. A, Amazon actually never ends up entering the market. They do in Europe, but not in the US. Blockbuster sees this and they're like, oh, Netflix is starting a price war. So nowbuster and netflix get locked into a price war and blockbuster further undercuts netflix and things go like haywire because 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 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 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 health metrics of financial health. If you don't, if you trigger those debt covenants, then 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 been a 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 more money than ever before to get nothing for that first month so it's like you know that 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 ad and 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 eichen of marvel

fame of uh where else has he showed up in our episodes so far? I don't think we've talked about memory. He was with Apple with like this guy. Oh my God. Hedge fund billionaire, 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 fire, files, a proxy battle to basically at the blockbuster annual shareholder meeting to 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 eichen just like replaces the whole board with like eichen cronies he starts bringing his son to board meetings who's just like some 26 year old dude and he's like you should give product for the hills yeah it's insane it's insane but fortunately the blockbuster management they managed to kind of like keep things on track and they decide with all this going on they need to raise prices back up um so netflix and they need to raise prices back up. So Netflix and Blockbuster both raised 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 4 million subscribers. They have a market cap of over a billion and a half. So up, what's that, 5x from the IPO three years ago.

They launched the netflix prize in 2006 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 was it 10 10 yep yep yeah everybody thinks that like it's gonna happen very quickly ends up taking like three years before it finally does get a, it's 2009. 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 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 market as total access, is essentially you sign up for yeah this is 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 like what Amazon is doing with, um, you know, Amazon go and prime now. And like, this is actually like pretty visionary. 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 2006 so scared that at sundance in the beginning of 2007 um well and they get scared it actually makes a huge impact so netflix growth flat lines 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 2007 reed hastings meets with the blockbuster ceo and he offers essentially a merger of the two companies and he says net Netflix will buy Blockbuster's online business from you for $600 million. So it'll be essentially like, 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 eichen 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 eichen 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 put his amount i can then hires a new ceo this dude from seven 11 who this guy. And to be clear,

this is, I can 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 is 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 going to beat them. And, uh, the, this guy who Carl Eichen brings in, I don't even remember his name. It's not worth it. Basically. Like 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 says he doesn't believe in online businesses. This is 2007. 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 going to totally defund blockbuster online. He thinks Netflix is a joke. Nobody's going to do it. Uh, he wants to bring totally defund Blockbuster Online. He thinks Netflix is a joke. Nobody's going to do it. He wants to bring back the heyday of bricks and mortar. Wants to make bricks and mortar great again. He wants to attract... Bring 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're Reeded hastings it's like this is like a gift from heaven 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. Best Buy 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. This new CEO of Blockbuster, he's like, we're going to buy Circuit City for a billion dollars. You literally cannot make this stuff up. You know what's better than one failing failing business you put two of them together we're gonna tie two anchors together and drop them into the ocean oh my god it's it's ridiculous everybody it doesn't actually happen because even carl eichen 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 going to 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 quickster or not i'm really glad that we uh this feels like such a good place to to hang oh totally i just like circuit city circuit city i mean again like the worst the worst

um all right i'm emotionally exhausted but we have other sections should we do narratives yeah going into narratives i want to recap just a couple things from reading the the s1 last night because i think they're interesting um so they sold 27 of the company in this ipo raised 82.5 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 20 of the company uh which will get diluted down to about 15 after the ipo tcv technology crossover ventures in in two different vehicles i i'm pretty sure i'm reading this right has 46 of the company yeah crazy pretty rare to see that at ipo a single firm with different ownership totally different era you look at

what they did there they were able to uh to raise you know i think in that with including that second little offering close to 100 million dollars they made no real promises in their S1 about sort of what they were going to do with that in any substantial way. They sort of just talked about they were going to spend on marketing, they were going to spend on improving the technology, they were going to increase the selection that they had. I mean, it wasn't like when we talk about what did they do with this capital, they run a flywheel business, so they just had to pour more money into the flywheel and have more money to be able to accelerate it. In looking back, we tend to do this narrative section where we do bulls and bears. Unlike other times like Facebook or like the Snap IPO, it's not like there were people writing these articles 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 going to work yet, but they're IPOing and 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 one of the only tech companies uh because people just watched all these dot coms go bust it was one of the only tech companies that was

posting 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 it 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 and cable companies will come back up in part two uh of the episode. If you can get consumers locked into paying you a certain amount every month, you can build a very stable, very predictable, very good cash flow business around that. Yep. All right. 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 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 car lichen yeah um if they hadn't opportunistically raised 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 40 layoff like you know yeah just a lot of things went their way here company is its skill and luck yeah totally totally i think maybe there is a world where they could have kept,

delayed the IPO longer. You know, they were at profitability. That would have been the wrong decision, I think, because Blockbuster was coming into the market. And access to capital in the private markets didn't exist like it exists today.

Yep, totally. Yep, they had to do this. Yeah. Tech themes? Let's do it it the first one that i'm thinking of is like and we've beat this to death on this episode so it's not gonna be like surprising to anyone but tabula rasa 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 still a little bit mind-blowing to me that i that I it's just very I think how fast as humans we forget the very recent past and what was a big deal and what wasn't is striking.

Totally. And yeah, just timing like not only a big wave, but like Netflix timed it so perfectly. And this is why we ended up breaking this episode into two. Like these are two different businesses. The DVD part 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 bought the domain netflix has dvd.com uh-huh no way you can go and access their dvd offering there interesting yeah wow i wonder i mean there still are people who i think they still have a few million dvd subscribers to this day i think and interestingly enough

from dvd.com this is how muddled this stuff gets you can rent blu-rays what about divics doubtful um okay i have a couple 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 lp program and bonus is to get deeper into like who are the people that like actually build these things and what are the 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 netflix and 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. And they tended to come from 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 at Amazon, a bunch of these folks in Netflix, and they're just so good. And I feel like 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.

Cowboy marketing. Yeah, it's become so cowboy, and it's become also just so dependent on Google and Facebook. Although the good growth people would find ways and tell you that their way isn't right on google and facebook there are still 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 going to have to raise prices the the netflix program with consumer manufacturers of of consumer electronics manufacturers to put the coupons in the boxes and modeling out exactly what was that was going to cost exactly what their growth rate was going

to be. You know, the going population and 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 want to call out that were stated in the S1 because one of the things you commonly see in these S1s is it's an 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 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 it's too hard to choose what movie that you want to watch but they had cinematch and the cinematch 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 s1 to shareholders which was interesting and i've got a few more but we're going to save those for part two all right should we grade this and we're going to grade the ipo here yeah so i was thinking about this and i'm like okay let's say they didn't because we've already covered like they 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 cash position they're sitting in is 15 million in the bank. They're not going to be profitable this quarter, but maybe the next and it's going to be super thin. So like you need cash from somewhere. 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's got to be some element of buying. They're already buying DVDs in mass, so they need to be able to do that to serve more customers. And you can buy deeper in the tail when you have more customers. They eventually do do deals with movie studios as they get bigger to buy DVDs at a discount. Yep. 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, really it's a flywheel business that 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 flywheel faster.

They sold 27% of the business. Like, good move. I mean, 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 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 was a good idea timing if they didn't need it for competitive reasons which they did it 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 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, I was concerned. Uh, that's when they tipped into like, we are a awesome business. It's 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 it's 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. Carbouts. Carbouts. 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, NK Jemisin'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

2015, I think, 15 or 16. 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 persecuted people have an immense power that, uh, can save the world. Uh, but they're persecuted and like, so you have to give, 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 going to be completely unrelated to the episode.

But I'm now realizing it's not at all. There's a Netflix show that I've been watching called The Good Place. And it's with Kristen Bell. It is really goofy, is really goofy but really good and really good sort of just like popcorn uh you know watch it for a half hour before you fall asleep it's that it's it's basically like a heaven and hell uh thing where kristin 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 just like, it's very tongue in cheek, but really good. And when I

picked it, I didn't realize that it was a Netflix show, but Netflix original content coming soon and in the next episode. Awesome. We want to thank our longtime friend of the show, Vanta, the leading trust management platform. Vanta, of course, automates your security reviews and compliance efforts. So frameworks like SOC 2, ISO 27001, GDPR, and HIPAA compliance and monitoring, Vanta takes care of these otherwise incredibly time

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