Netflixed: The Epic Battle for America's Eyeballs

PROLOGUE

IT IS EARLY MORNING ON a workday in the spring of 1997. A dusty maroon Volvo station wagon pulls into a commuter parking lot in Scotts Valley, California, in the foothills of the Santa Cruz Mountains.

The dot-com bubble is on the rise and the parking lot is lousy with twenty-something computer geeks, male and female, gathering in carpools to take them over the hill to Silicon Valley.

They carry canvas cases with logos: Apple Computer, Sun Microsystems, Oracle Corp., and other hot technology companies. Most wear the Valley uniform of board shorts or Levis with a wrinkled T-shirt, a fleece jacket, and some form of Teva footwear. Several have bed head from not showering and a dazed look from long-term lack of sleep.

The Volvo pulls toward a space on the deserted far side of the lot, where a shining steel blue Toyota Avalon is the lone occupant. The Toyota driver sits in the driver’s seat, door wide open. At the sight of the Volvo, the Toyota driver jumps out of his car.

He is Reed Hastings, a tall lean man in his midthirties, wearing pressed Levis, a white T-shirt under a worn corduroy button-down shirt, brilliant-white running shoes, and black socks. He has close-cropped brown hair, a neat goatee, intense blue eyes, and a perpetually guarded expression. His normal posture, slightly forward and a bit hunched in the shoulders, reflects years of staring at computer monitors in pursuit of beautiful mathematical algorithms to define all manner of natural and man-made phenomena.

Hastings paces impatiently, his hands jammed into the pockets of his jeans, as he watches the Volvo approach, park off-kilter, then vaguely repark.

Finally satisfied, the driver of the Volvo, Marc Randolph, gets out, stands up, and greets Hastings over the roof of the Volvo.

Randolph, in his late thirties, is as happy-go-lucky as Hastings—who is his boss at a soaring software company—is intense. Loose-limbed and lanky, with thinning dark hair, Randolph has engaging brown eyes, a bemused, wide mouth, and an easy laugh. Randolph is Hastings’s mirror opposite, a people person, exactly the guy you want to be your marketing manager when you are not.

Despite their differences, there is an obvious ease, trust, and camaraderie between them: They share that confidence conferred by privileged upbringings and a passion for spinning ideas into businesses.

Randolph, clad in a fleece jacket, T-shirt, torn jeans, and flip-flops, circles the car and stands next to Hastings.

It came, Hastings tells him.

Hastings reaches into the Avalon, digs an oversized rose-colored greeting card envelope out of a Pure Atria briefcase on the passenger’s seat, and holds it up. Randolph swallows hard, and nods for Hastings to go ahead and open it.

Hastings takes an antique monogrammed silver penknife from his shirt pocket and slits open the envelope. He pulls a silver compact disk out of the envelope and turns the disk in his hand, minutely inspecting it. It is in perfect condition.

It’s fine, Hastings says flatly.

A huge smile spreads across Randolph’s face.

Huh. This online movie rental thing might actually work, Randolph says.

• • •

LIKE ALL GOOD stories, the one about the founding of Netflix Inc., the world’s largest online movie rental company, mixes a little bit of fact with some entertaining fiction. But the version above is closer to reality than the company’s official story—the one about how tech millionaire Reed Hastings had an epiphany for his next company after returning an overdue movie to his local video store, and later dreamed up its signature subscription model on a treadmill at his gym.

"The genesis of Netflix came in 1997, when I got this late fee, about $40, for Apollo 13. 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," Hastings, Netflix’s chairman and chief executive, told Fortune in 2009, one year before the magazine named him its Business Person of the Year.

I didn’t know about DVDs, and then a friend of mine told me they were coming. I ran out to Tower Records in Santa Cruz, California, and mailed CDs to myself, just a disk in an envelope. It was a long twenty-four hours until the mail arrived back at my house, and I ripped them open and they were all in great shape. That was the big excitement point.

As a financial journalist, I heard that story a lot in the seven years I covered Netflix along with a handful of other U.S. entertainment companies and their executives. I never gave Hastings’s story much thought back then. It was simple and straightforward and conveyed perfectly what Netflix was all about: DVD rentals by mail that you can keep as long as you want without paying late fees.

The odds against Netflix surviving were long when I took over the Los Angeles entertainment industry beat at Reuters in spring 2004. Blockbuster, the world’s largest movie rental chain, was preparing to launch its own online rental service, and online bookseller Amazon was lurking on the sidelines, posting employment ads for software developers for a yet to be announced movie rental service. Retail behemoth Walmart Stores was making a halfhearted stab at protecting its enormous DVD store sales by offering online DVD rental, and Hollywood movie studios were belatedly forming joint ventures to test movie downloading. Netflix had just hit 1.9 million subscribers and was still showing losses as often as it booked profits.

In the ensuing years I watched Hastings and his underdog company claim an ever-larger share of the growing online rental market with gutsy moves that defied Wall Street predictions about the size of the market and the strength of his larger rivals.

I saw a gifted and disciplined team change the way people rent movies, not for the money, but for the challenge of disrupting a real world industry and taking it online. In the pursuit of elegant software and intuitive user interfaces, they created a tastemaker to rival Apple, an innovator on the order of Google, and a brand power equal to Starbucks. Netflix also became a story about how powerful algorithms perfected in a Netflix-sponsored science contest spawned technological breakthroughs that influence how anyone with a product or idea to sell rounds up likely buyers. By 2010, with a long-delayed international expansion underway, Netflix had changed how half the world watches movies.

I thought I had the story down cold when in 2010 I began to research and write a book about Netflix’s rise from a start-up with no clear path to profitability to a $4 billion movie rental titan with a stake in everything from postage rates to Hollywood movie deals to federal rules on privacy, broadband use, and Web traffic.

I knew I would need good outside sources to solve a few mysteries about the company’s early days, because Netflix’s communications and marketing teams were excellent at staying on message with reporters and investors—and especially with consumers—on issues the company wished either to control or to avoid talking about.

Some of the questions for which I could not get answers from Netflix included: What happened to Netflix’s other founder, Marc Randolph, and why is he never mentioned? Why was the Apollo 13 founding story initially set at a Blockbuster store in Santa Cruz, then changed in 2006 to a now defunct mom-and-pop video store in La Honda? Why did founding team member Mitch Lowe leave to start his DVD rental kiosk company Redbox, now one of Netflix’s main competitors, instead of launching it at Netflix?

At first these seemed like minor details that had little bearing on the story that I knew so well and had watched unfold from a front-row seat in the financial press. But answering one question only led to another, and soon I was down a rabbit hole that changed everything I thought I knew about Netflix.

What I found was much richer and more nuanced than the official story. The complete history of Netflix comprises a long and untidy striving for greatness with multiple disasters, lucky breaks, betrayal, and heartbreak.

The company does not gratuitously mislead the public. The official story is simply more elegant and useful, and everything at Netflix, from its 2,180 corporate employees (who turn over at an annual rate of 20 percent) to the scripts followed by its executives on quarterly conference calls, must serve the company’s goals or be eliminated.

After all, discipline and focus account for how a tiny, broke Silicon Valley company slew three giants of the $8 billion movie rental world (the Blockbuster, Movie Gallery, and Hollywood Video chains), warded off Amazon, and forced movie studios into the digital age. Netflix is now employing the same tactics to undermine cable and satellite providers, but in an outwardly nonthreatening way, the better to sneak into these new markets and disrupt the competition.

We’re small enough that we don’t want to incite World War II or World War III with the incumbents, Hastings said in early 2011, shortly before Netflix announced that its subscriber base had surpassed that of number one U.S. cable provider Comcast.

Hastings seemed to guide his company by stars invisible to others, often abandoning solid revenue sources or related businesses to pursue the one thing he was determined to do better than anyone—rent movies online.

Where Hastings pursued that goal, Wall Street analysts and the financial press saw only a seemingly simple business model (a software program, a bunch of warehouses, and some DVDs) and bigger companies with the means to buy what Netflix had invented. Their bleak forecasts resulted in frequent meltdowns for Netflix’s stock price, which appeared not to bother Hastings. That his judgment proved correct, even visionary, in the face of market pressures was an added attraction to a story I believed showed the best of entrepreneurial culture in America.

It was in the wake of the terrible stock market crash of 2008 that I began to contemplate writing what I believed was a Wall Street fairy tale, in which the best ideas, a clean balance sheet, and the flawless execution of an inspired business plan allowed a company like Netflix to vanquish a bloated corporate giant or two and come out on top.

I got that and a lot more, starting with a conversation I had with Netflix’s other founder on a bright, windy day in Santa Cruz, California.

• • •

I WASN’T SURE what to expect when we met for the first time at a breakfast joint in Los Gatos in August 2010—no one else had been able to tell me the circumstances that had led to Marc Randolph’s departure from the company he helped found.

The fit, animated man who walked up to my outdoor table dressed in a fleece pullover and jeans showed every sign of enjoying a rather footloose life since leaving Netflix. He sat down, ordered eggs Benedict, and plunged into a tale that upended a lot of what I thought I knew—starting with the story of how Hastings’s late fee for Apollo 13 resulted in the founding of the company.

That’s a lot of crap, Randolph told me. It never happened.

He explained that the Apollo 13 story started as a convenient fiction to describe how Netflix’s rental model works and became confused with its origins, because people wanted a rage against the machine–type story.

Six months and several conversations later I persuaded Randolph to show me where the true Netflix founding took place, which was on a quiet stretch of downtown Santa Cruz.

At Randolph’s suggestion I took a commuter bus from Silicon Valley over the hill, on winding Highway 17 to simulate the drive he and Hastings made each day from their homes to and from the Sunnyvale offices of Hastings’s software company, Pure Atria. On that commute in early 1997, they tossed around ideas for a new business that Randolph planned to start when he left Pure Atria, then in the process of merging with its largest rival, Rational Software.

Randolph, then head of corporate marketing, had long been particularly fascinated by how consumers respond to direct mail—catalogs, mail-in offers, coupons—or what most people, including Hastings, considered junk mail. Randolph saw in the Internet an instant way to monitor consumer response to such sales pitches, adjust the online store to make it more inviting, and theoretically boost sales. Direct mail on steroids, he called it.

The drive on the two-lane mountain road through fog and forest was nerve-racking, and I felt as though I had arrived in a quaint Alpine ski town when the bus stopped to let off passengers.

Randolph picked me up in his immaculate Volvo station wagon at the tiny bus station in Scotts Valley, an affluent bedroom community in the foothills of the Santa Cruz Mountains where he had lived for about fifteen years. His Victorian farmhouse, tucked away on fifty acres of forest, is about three miles from Hastings’s former home, a square yellow Victorian about a block from the ocean in Santa Cruz.

We drove to a nearly empty faux Mediterranean office park off Highway 17, where he and a team of about a dozen marketing specialists, programmers, and operations staff launched the Netflix Web site on April 14, 1998.

Hastings, who was studying for a master’s degree in education at Stanford University and running a tech industry lobby group at the time, came that day to wish them luck. The one-room space of about a thousand square feet, where Randolph ran Netflix for nearly two years, was at the back of the complex.

Next we headed three miles south, toward Santa Cruz. Randolph followed the coastal road and pointed out a wide, neatly groomed path curving along cliffs overlooking Monterey Bay, where prosperous-looking adults strode along in pairs and threesomes, wearing baseball caps and fleece jackets bearing tech company logos.

What looked to me like groups of stay-at-home moms and dads taking exercise and sanity breaks actually could have been staff meetings of homeless tech start-ups. Randolph told me that many business plans and deals are hammered out along this stretch of road.

Santa Cruz, especially the section populated by well-to-do residents on the west side of the San Lorenzo River, is vehemently antigrowth and antimansion, and even fought a widening of Highway 17 that would have shortened the hour-long commute to Silicon Valley. The town’s east siders share their wealthy neighbors’ isolationism—not so much to keep out vulgarian McMansion builders as to preserve a surf-shack culture reminiscent of a 1960s beach party movie.

We turned north toward the center of town, near where the Pacific Coast Highway runs inland for a few blocks through a tony little business district, before it heads back toward the California coastline. Randolph parked the Volvo at a meter on Pacific Avenue, and we began to walk—past a vintage movie theater, a few upscale chain stores, and local boutiques.

He pointed out a café called Lulu Carpenter’s, a hip coffee joint where people sat out front at sidewalk tables in the weak morning sunshine. He and Hastings often met at this café to discuss business—and formed the plan that brought Netflix to fruition.

One particular day their debate centered on how to distribute the movies they hoped customers would rent via a hypothetical e-commerce Web site, and they decided they had to test whether the new DVD format that Randolph had heard of could travel across the country on a first-class stamp and survive the hazards of bulk mailing.

They couldn’t get their hands on a DVD, then available in only a half-dozen test markets, but a used book and music store called Logos Books & Records a couple of blocks down the street sold compact disks. When we drove up that day a giant Borders bookstore was liquidating its stock and preparing to shut down, another casualty of the inexorable move to online distribution of media that its parent company embraced too late. I wondered if Logos’s staff had any idea of the role their iconic indie store played in helping Netflix bring down another huge bricks-and-mortar entertainment chain.

A few doors down from the record store was the gift shop where Randolph and Hastings bought a greeting card with an envelope large enough to accommodate the CD after they stripped off its packaging.

They threw away the card, stuffed the CD into the envelope, and addressed it to Hastings’s home. They then walked to the central Santa Cruz post office, where they paid for first-class postage and sent the CD on its short but crucial journey.

They would later learn, through close collaboration with the U.S. Postal Service, that local mail was hand-canceled in Santa Cruz and not sent through postal service sorters—a fact that could have changed everything had they known it then, Randolph told me.

A day or two later, the two met up for their morning commute to Sunnyvale.

It came, Hastings told Randolph, as he climbed into the car. It’s fine.

And I thought, ‘Huh, this might work after all,’ Randolph said, as he drove me back to the bus station. If there was an ‘aha moment’ in the story of Netflix, that was it.

CHAPTER ONE

A SHOT IN THE DARK

(1997–1998)

THE DAY HE FOUND OUT he was about to lose his job, Marc Randolph thought, I’m going to start a business.

He had no idea what sort of business, only that he wanted to sell something on the World Wide Web. His new company would be the Amazon.com of something besides books. He wasn’t sure what, exactly.

It was early spring 1997, and a few months earlier Randolph had become the head of corporate marketing at a Sunnyvale, California, software company called Pure Atria.

In late 1996, Pure Atria had acquired the nine-person software start-up for which Randolph worked as chief of product marketing. He figured he would lose his job in the merger, but Pure Atria’s thirty-six-year-old cofounder and chief executive, Reed Hastings, had asked him to stay and promote Hastings’s rapidly expanding company.

Randolph spent the dawn of the Internet age at a series of short jobs at start-ups after devoting seven years to building a direct-to-consumer marketing operation at software giant Borland International. He found the intense bursts of highly creative work suited him, especially when the companies were acquired or went public, and he and the other managers exited with healthy severance packages, chunks of valuable equity, and time off.

It was a common dance in 1990s Silicon Valley, a verdant and sunny groove of flat land sandwiched between the southern reaches of the San Francisco Bay in the east and the Santa Cruz Mountains in the west. Start-ups bloomed for a year or so, watered by plentiful venture capital dollars, and were quickly swallowed up by private investors or large, rich companies fishing for the next big innovation in software, biomedical engineering, telecoms, or the ever-evolving Internet. It was the new gold rush, and venture capital investors would pour more than $70 billion into Silicon Valley start-ups before the decade was out.

Things moved so quickly and money was so plentiful that most entrepreneurs had no chance, or any need, to turn a profit, or even run to their companies for long.

The pace was grueling, and everyone was expected to bring his or her top game each day for months of sixteen-hour days, until it was clear whether a fledgling business would fly or crash. The money was easy, but in exchange the entrepreneurs had to return tens, if not hundreds of times the VCs’ initial investment.

Extreme risk was part of the equation and a factor that everyone—down to landlords and office equipment rental companies—took for granted, because the payoffs, when they came, were mind-blowing. And when things didn’t work out, it was no big deal to shrug your shoulders and hop onto the next great idea.

Thinking that he could use a few months off to travel with his wife, Lorraine, and hang out with their three small children, Randolph hesitated to accept Hastings’s offer to stay at Pure Atria.

The company made software for detecting bugs that often cropped up in computer code when multiple developers worked on it. Its customers were other businesses that developed software programs. Pure Atria was founded in 1991 by Hastings and Mark Box and had grown rapidly through a series of acquisitions; it had new offices in Europe and Asia, whose marketing departments would report to Randolph.

He would have felt no fear or stigma at the prospect of being let go with a nice severance—jobs were plentiful in the Valley, and as a cofounder of a glittering roster of start-ups, Randolph knew he was a catch.

Staying at Pure Atria was a high-pressure job, but next to the hectic software development schedules, long days, and chaos of start-ups, the regular hours and steady if unexciting task of promoting Pure Atria seemed like leisure to Randolph. He met with Hastings a couple of times and decided his prospective boss was intense and extremely smart.

Despite having completely opposite personalities, Randolph and Hastings had a lot in common. Both were East Coast transplants from wealthy families who attended small private colleges and wandered about for a few years before settling into careers they were passionate about.

Both had tremendous enthusiasm for the high-tech industry that was blossoming in Silicon Valley, and each was a strong leader in his own way, inspiring protégés to throw around the word genius with conviction.

• • •

WILMOT REED HASTINGS, Jr., came from America’s patrician class, and it showed in an easy confidence in his own abilities and opinions. His mother’s family were founding members of the Social Register; their births, marriages, and other life passages were chronicled in the New York Times society pages.

His maternal great-grandfather Alfred Lee Loomis applied a mathematical genius to investing and became one of the few on Wall Street to profit handsomely from the 1929 crash. Loomis was viewed as cold and odd by his wealthy and pedigreed peers, mainly because of his obsession with using physics to develop weapons technology. Loomis lavished his fortune on an experimental physics laboratory in a mansion in Tuxedo Park, New York, and invited the world’s most brilliant scientists to work there on technology for military applications. Their scientific breakthroughs led to the development of radar, the atomic bomb, and global positioning systems. After World War II the federal government formed the Defense Advanced Research Projects Agency essentially to take over the Loomis lab’s role as a pure defense research lab. Scientists at DARPA developed the precursor to the World Wide Web to allow computers at far-flung locations to share data about national security threats in real time.

Hastings’s mother, Joan Amory Loomis, was presented to society at the Boston Cotillion and the Tuxedo Park ball in New York in 1956. She attended Wellesley College and married his father, Wil Hastings, a magna cum laude graduate of Harvard College, in 1958 after both spent a year studying at the Sorbonne in Paris.

Hastings, the first of their three children, was born in 1960. He grew up in the liberal and discreetly wealthy Belmont suburb of Boston, attended private schools, and bucked the family tradition of attending Harvard or Yale, instead choosing Bowdoin College, a liberal arts school in Maine.

Like his great-grandfather Loomis, Hastings was drawn to mathematics, a pursuit he found beautiful and engaging. He won Bowdoin’s top math honors in his sophomore and senior years and, after graduating, set out to see the world.

Hastings hoped to attend the Massachusetts Institute of Technology’s graduate computer science program after completing a three-year stint as a Peace Corps math teacher in Swaziland, but he wasn’t admitted. Instead, he earned a graduate degree from Stanford University and found himself swept up in Silicon Valley’s technology boom. He started his first company, Pure Software, at age thirty. Pure went public in 1995 and two years later acquired the Boston software company Atria and Integrity QA, a start-up where Randolph was a founding team member.

• • •

RANDOLPH SAW IN Hastings an equal in entrepreneurial spirit and drive, and so he took the marketing post and moved to Pure Atria’s headquarters shortly before the end of 1996. They began working together on speeches and product launches. On their first cross-country commercial flight together to Atria, Hastings sat down, buckled his seat belt, and turning to Randolph, proceeded to describe that company’s inner workings and his plan for integrating it into Pure—for the entire six-hour trip.

Randolph was impressed with Hastings’s command of the minutiae of his recently acquired subsidiary and his determination that it would not capsize Pure in the process of combining operations.

Warm and voluble, Randolph loved nothing more than to be argued into or out of an idea or point of view. Hastings, cool and analytical, could be stubbornly sure of himself. Somehow, the relationship worked. Hastings’s supercomputer mind perfected the logic of a business plan or organizational structure or product, and Randolph sold it—to customers, employees, or the public.

In spring 1997, Randolph began assembling his marketing staff at Pure Atria. One of his first calls was to Christina Kish. The athletic and pretty thirty-two-year-old California native was a tightly wound product manager who had gained her direct-marketing chops at the software industry’s biggest names, Software Publishing and Intuit. She had interviewed Randolph at the Mountain View–based desktop scanner manufacturer Visioneer; she had liked the mix of his laid-back style and sharp intellect and agreed he should be her boss.

Randolph had an appealing wit and a sensitivity about people that was uncommon in Silicon Valley’s male-dominated culture. He also possessed unparalleled abilities as a public relations strategist, as Kish learned during their wild ride at Visioneer, which went from struggling unknown to industry leader shortly after shipping its first product, the PaperMax scanner, in 1994.

Cutthroat corporate politics annoyed both of them enough that they left Visioneer after short stays, but Kish had enjoyed working with Randolph, especially appreciating the work atmosphere he created—focused and intense yet collaborative, as if they were throwing a big party together. So when he called three years later to offer her a comparatively low-stress job building a customer database at an established software company, she jumped. She gave notice at the dial-up Internet service provider Best Internet and left for a two-week vacation in Italy with her husband, Kirby, intending to join Pure Atria when she returned.

Next, Randolph wheedled Therese Te Smith, another protégé, into leaving Starfish Software’s marketing department. Smith, a baby-faced forty-year-old with long curly brown hair and the broad accent of Boston’s blue-collar North Shore, had been doing consumer-facing marketing for the hot new Sidekick personal organizer developed by Starfish, a former division of Borland. But after Randolph’s call, Smith quit her job and planned to land at Pure Atria in early April, after taking a few weeks off between gigs.

As Randolph negotiated salaries and