Excerpted from Entrepreneurship: A Real-World Approach, 2nd Ed, now available
Co-founded by Reed Hastings and Marc Randolph, Netflix launched in 1997 as an online DVD-rental and sales business. Two decades later—and after experiencing some growing pains along the way—Netflix boasted more than 75 million members in 190 countries, viewing over 125 million hours of movies and TV shows every day through streaming video on demand.
Initially, Netflix was a trailblazer. DVDs were then a new format. In fact, few customers had DVD players—they were still using videotape players and going to their corner video store to rent tapes.
“Ironically, this dearth of players worked toward our advantage,” according to co-founder Randolph.(1) Few movies were available on DVDs because DVD players were still an emerging technology. But Netflix carried all available titles on DVD at that time. So Netflix struck agreements with manufacturers of DVD players to tuck Netflix promo cards inside their boxes. Anyone who bought a DVD player now knew where to find DVDs. Netflix was well positioned to grow alongside the popularity of DVD players.
Still, the company struggled during those early days and had yet to figure out a profitable business model. All changed when, in 1999, Netflix introduced a subscription service. Whether customers rented two movies a month or 10, they paid the same monthly rate. Customers didn’t have to worry about late fees or due dates, as they had at their corner video rental stores. Netflix mailed customers their picks in its signature red envelopes, and the customers watched and then returned the discs. Once Netflix received those DVDs back, it sent out the next DVD the customer had chosen.
The “unlimited” rental model turned the company’s fortunes around. The company not only survived, it flourished. By 2002, with over 600,000 subscribers, Netflix issued its IPO (it trades on the Nasdaq under the ticker symbol NFLX). Just three years later—in 2005—the company subscriber base had skyrocketed to 4.2 million users.
But technology keeps evolving, and Netflix executives had to think strategically. As more homes received broadband Internet service, they were able to “stream” movies virtually instantaneously rather than getting physical DVDs. In 2007, Netflix unveiled its on-demand streaming service.
With Netflix offering both DVDs to rent by mail and streaming movies available on demand, it essentially operated two businesses with two very different business models. Delivery differed greatly—one over the Internet and one by mail—as did costs. A DVD rental business involves more expenses to operate—the DVDs themselves, inventory management costs, shipping costs, and the cost of processing returns. Instant video streaming requires high up-front costs of infrastructure and technology—as well as the maintenance costs that prevent the site from crashing when millions of people use it simultaneously.
Because the two businesses competed with each other, essentially, Netflix disrupted itself.
In summer 2011, the company thought it had come up with a good solution to its conundrum—trying to focus on two different business models within one company. On July 11, Netflix announced it would separate its streaming-only and its DVD rental-only plans, and give customers the option to subscribe to both. Whether customers chose the streaming-only plan or the DVD rental-only plan, they would pay $7.99 per month for either one. If they wanted to both stream video and rent DVDs, they would pay $15.98.
Customers were outraged. Before the announcement to spin off the DVD-by-mail service, they had paid $9.99 per month to rent DVDs by mail and could also access Netflix’s streaming video library. In other words, for the same service they already had—DVD rentals and access to online streaming—subscribers who wanted to keep both options faced a huge price hike. Netflix quickly lost one million customers.(2) Its stock also plummeted.
What did the management do? On September 18, 2011, Hastings wrote a post on the company’s blog with the opening lines “I messed up. I owe everyone an explanation.” In that same post, Hastings announced that the DVD-by-mail business would be spun off into a new entity called Qwickster, with its own separate website.
Whoops. Less than a month later, Qwickster was dead. On October 10, the company made yet another announcement. Taking again to the company blog, Hastings wrote, “It is clear that for many of our members two websites would make things more difficult, so we are going to keep Netflix as one place to go for streaming and DVDs.”(3)
The Netflix story is not over yet. New technologies and new competitors keep challenging its business model. What Netflix executives have learned, however, is that they have to think strategically, stay nimble, listen to customers—and remain humble.