Acquired - Netflix (Part 1)

0:00Yep, I'm 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 but my biggest complain is the lack of scuzzy That's a teaser quote right there Welcome to season three episode eight of acquired the show about technology, acquisitions, and IPOs. I'm Ben Gilbert. I'm David Rosenfall. 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

1:08Believe this one 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...

1:28This is why we have to do this as a two-parter because when we first started researching this, we didn't think of it that way, but they really are two different companies here. There's Netflix pre-streaming and Netflix post-streaming. We're going to cover the pre-streaming today.

1:44Well, 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-acquired. That's K-I-M-B-E-R-L-I-T-E.fm-slash-acquired.

2:10On 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. All right, listeners. Now is a great time to talk about a new partner of ours here on Acquired, LaGoura, the agentic operating system that is redefining how the world's best legal teams work.

2:36Yup, it's sort of obvious that AI is going to completely change the legal industry. I bet most of you listening have dropped a contract into some sort of AI chatbot out there. Lugora took that insight and asked the question, what if you really built something with that power from the ground up for the legal industry? So the founders did exactly what great founders do, operate with obsessive customer focus. They embedded inside a massive law firm.

3:02for months. They sat with the lawyers just watching how the work really gets done. And that's how you get features that customers love, like tabular review, where you drop in a folder of hundreds of contracts and it pulls every key term into a grid a lawyer can actually work with. Legora's bed here is interesting. Since it lets each lawyer handle more complexity, any given person can increase the quality of their work and do higher value work. And this means that the pie can grow even as each individual task takes less time.

3:32And they recently launched LaGora agent offering greater intelligence and performance. The agent lets lawyers set an objective. Then it can handle the planning and the execution and delivery of the final product. Legal teams get to maintain full control and transparency since they're still involved where judgment is required. And LaGora works where you already work. You can use it within Microsoft Word while redlining or drafting. The early LaGora numbers essentially speak for themselves, when they have a head-to-head pilot with their top competitor, they win 70% of the time. LaGora now has over 100,000 lawyers on the platform from 1200 legal teams in 50 countries, and crazily, they went from 1 million to 100 million in ARR in about 18 months. Truly insane numbers, and that is the real test.

4:24Plenty of things demo well, but the question is whether a busy associate actually reaches for it during crunch time or whether a partner trusts it before going into a conversation with a major client. If your legal team wants to check it out, whether you're a law firm or you're in house at a company, you can learn more at logora.com slash acquired and just tell them that Ben and David sent you.

4:45All right, David, you're ready to take us in with the acquisition. I suppose the IPO history and facts. Well, there would be lots of acquisition offers back and forth as we go here, but I wish I didn't know until I started reading Dave and I both read this. There's a great book by Gina Keating called Netflix Netflix. Yeah. This is really fun. When we were discussing what episode to do for this one, we're like, okay, we're getting kind of towards the end of season three. We want to do like a a big, important splashy episode. Let's do one of the fang companies, Netflix. I thought, you know, Netflix seems pretty straightforward. Like, read Hastings, like, very solid dude, you know, is for sure. But like, 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 upfront, this is part one.

5:45We'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 leading 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.

6:12from Santa Cruz of all places, is fed up with movie rental late fees. 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 becomes himself, you know, a paragon of Silicon Valley, statesmen. Of course I'm talking about Mark Randolph.

6:41Not Reed Hastings. This is a true statement, the illustrious CEO of Netflix. The illustrious CEO of Netflix. 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.

7:08Yes, 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 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, Daniela next tool. And liquor actually came out of Netflix, I think.

7:37which 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 gonna give you that, then we're gonna tell you the true story. So, official story, Reed Hastings, he has been a successful technology entrepreneur in the Enterprise Base, 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.

8:07that gets changed not to a blackbuster after a lawsuit between blackbuster 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. Uh, we've seen this many times. So he's 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.

8:36Quote, 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.

8:58And 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.

9:14Another fun element on this story is the reason that he talks about being on the treadmill is because 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 what is the Netflix business model and what was the opportunity to be found.

9:43We've talked about this a bunch on the show, but I actually don't think there's anything wrong with this. Especially in the early days of a company, you need to communicate your value prop and stories or how you do that. Something like this happened, it just wasn't as clean. What's the real story?

10:02One 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 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.

10:24And 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.

10:43Tools 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 background before starting Pure? Not really. Not really. So go for it.

11:05All right, so 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 Bowden undergrad on the East Coast. But yeah, that's how we got out to the Valley.

11:33He'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.

11:43taking 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, you know, 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 at the age, which was firing CEOs as soon as they humanly could, or firing founders. Okay, so as Ben alluded to, pure hatred at this point is publicly traded. It's basically a roll-up. They acquired hatred. They acquired a bunch of companies that are all in the space. They're rolling up and consolidating.

12:27Randolph, Mark Randolph, had been at one of the small companies that Pure Atria had acquired. And after the acquisition, he 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.

12:45So it's 1997. One final piece of this role is happening, though, and that's the biggest piece, which is there's a huge merger that's about to happen between Pierre 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.

13:06valued at just under a billion dollars. Yeah, cute, just under a billion dollars. And read 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 as 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 to be here place to a dronish. And I'm quoting here, when does the day end sausage factory? And he says, we got more bureaucratic as we grew. And his thinking at that time is whatever I do in the future, and the next thing I have to start, we have to think of systems so that we don't end up like that. Yeah. And that will come back into play.

13:55Reed is about to become hugely wealthy, like he's still very young, hugely wealthy, and his plan is to basically write 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 masters jointly. Reed's gonna go do this one year grad program in education with the intention of he's going to become an education focused philanthropist for the rest of his life.

14:22Randolph, though, he's not so, you know, not about to become so wealthy. 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.

14:48And it just so happens that in addition to working together, Reed and Mark both live in Santa Cruz. So this, as 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.

15:15The mountains are awesome, and it's beautiful, but they're very high, and it is very remote. 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 the whole vibe is beach town, surfer town, not everything we think of as Silicon Valley. So as a result, Reed and Mark are often carpooling.

15:34together back and forth between Sunnyvale where Pure 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 ink because the ideas get the dogs to eat the dog food. So kibble ink dog food. Anyway.

15:59He starts a shell company. They're spitballing stuff. He starts thinking about has been alluded to. We'd worked in Macworld. 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, Compuserve, customer acquisition techniques that I think we've referred to in the past of just mailing out tons and tons of CDs to potential customers. How many?

16:26AOL 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.

16:43AOL coasters. I feel somewhere now. Well, the important thing that I want to say about Randolph here is it basically his background, but you know, before Puratria, he's a publishing guy. He knows the publishing industry inside it out and kind of stacked on top of that. He's a.

16:58Data and analytics guy, which didn't really exist in meaningful form. There was no digital data analytics then, so he was frequently tasked with things like serving audience and trying to understand who are our readers. His philosophy as he 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.

17:23and how can we build 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 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.

17:52called DVD. It's just just getting launched. It's in the 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 a local record store, not tower records in Santa Cruz, buys a CD, goes to a gift card, buys a very large birthday card, and stuffs the CD and mails it to read Hastings House. The next day or two, when they're meeting to commute together, reads, got the mail. Is it gonna come? Is it gonna come? He's got the envelope and he's like, it came.

18:38It's fine. Dude, 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...

18:59being 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 what this work with tapes and they were like, nope, shipping costs are too high. Shipping costs are too high and just logistically, like he got a storm and catalog, like the CDs are tiny, although not as tiny as bits. So Netflix, it's born, it's off to the races. So what happens? Read is like great.

19:26I'm going off to Stanford, but I've got all this money. I think I'm going to dabble in angel investing. I'll fund this company. So just like Elon did with Tesla, Reed leads the first round of funding in Kibble Inc.

19:40which in a little bit becomes Netflix. Read Invest $2 million. Randolph becomes the CEO. Read is just an investor in on the board. They recruit the initial team. They set up their first office in Scots 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...

20:06Unsurprisingly, it's actually a pretty good idea. So the home video industry at this point is now bigger than Bach's office for film and television. I guess mostly film at this point.

20:17It'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 the 800 pound gorilla. I want to quote the S1 here because 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.

20:44And 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 on in-home filmed entertainment, representing approximately 80% of filmed entertainment blah, blah, blah. Goes on to talk about exactly what David just said that the largest portion is rental. I was reading the S1 and I was just chuckling that like, The story at any stage is always the same. What do you do? Why could it be huge? Why is your tail? 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.

21:26is 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 regulatory issues 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, I forgot that. This whole industry is enabled by a Supreme Court ruling. And fortunately, in a very sort of Bezos way, where Bezos always credits the infrastructure that was laid before him that allowed the company to exist, the internet, UPS, etc.

22:20you know, this wouldn't have been possible if what they had to do was go and lobby and get laws changed at the outset. Infrastructure had been been laid for them. Go vote. It's important. Hopefully you already voted in these elections. Yeah.

22:33I assumed they had to pay some form of royalty back to the content holder every time they rented it. I mean the 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 dollars or whatever for a movie and then you rent it out for like $3 and you rent it.

22:5650 times or something. That's awesome. It's the same business as scooters today. 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. All right, listeners. Now is a great time to tell you about a longtime friend of the show, Vanta. AI has scrambled the whole security picture. It used to be that you proved that you were secure once a year, an audit or a static PDF, then everyone would not and you're done.

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24:56Okay, 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 gonna come back into the story.

25:06Later, 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 just 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.

25:56Together, they, and they'd hired a couple people from pure, a couple folks that they'd worked with in the marketing department there. They all set on the settle on Netflix as the name and 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 branding and logo.

26:19I think show notes can be 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 awesome. We 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 used today, except 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 nighties. Yeah.

26:48So it's purple, it's bad. It's bad. Okay, Netflix. So what do they do? This is brilliant. And I think this is driven 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 love it. Well, because these things are like 600 bucks. Like getting a DVD player was like, ooh, I'm done. I was like over 1000 bucks at this point. In 1997 dollars. So like the people who are buying these things are super techy, super early adopters, like the perfect market to adopt Netflix and give, you know, feedback here.

27:43isn't it 640 by 480 like it's there's not a lot of that like yeah I think that I think it might even be less like you know it's 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 have no I actually have no means to play any discs yeah I mean either well wait for stay tuned for part two so they officially launch the product in April 1998. Remember, they've been building all this momentum and 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.

28:35I mean, the magic that they came up with was the business model of rather than paying for 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 the consumer electronics manufacturers were so powerful this time. We're talking Sony, Shiba, Panasonic, all these Japanese, and some US, I forget which ones are US companies. Anyway, these guys are dominant. And they know the DVD machines. That's their next drug that they're gonna sell US consumers. So they're pushing it hard, best buys, pushing it hard, circuit cities, pushing it hard. Netflix goes and they do deals with these consumer electronics manufacturers to get Netflix promo coupons.

29:29Inserted into the boxes with DVD players like talk about an awesome distribution heck like it doesn't get it any better than that And this was a big part of their customer acquisition for many many years and it works like amazingly 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 gonna use that. Like, you know, we're just gonna stick with VHS. It feels short-sighted to me.

30:05in 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 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.

30:52Not 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.

31:16That's like way less or known than even like beta max or HD DVD or any of these alternatives. It was the beta max of the optical disk era. So blockbuster was kind of waiting on the sidelines to see what would happen before they made the big bet and through their way 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.

31:37But fortunately it worked. Um, so that's it. It ended up becoming like a digital, like a, not street, but like, it was like a, yeah, I was like a filing coder format. And I used to have like a divics player on my Mac that I could like play divics 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.

32:03Netflix 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, start up you'd launch you're at a million dollar revenue run rate.

32:20four months in, like, super impressive. And super capital efficient considering they were buying all these DVDs. Like a camera, what did they, they had only raised the money from read to date, right? Yeah, only the two million dollars. Well, capital efficiency.

32:34Yes, yes, yes. But with all this growth, they are just burning huge. 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 gonna end up being a couple. 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.

33:02they realize that the Netflix actually had this perverse aspect of their business model in the DVD streaming era that they're very best customers who use them the most cost them the most money. So they 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, 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, that unit.

33:48So 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.

34:13It's gonna come back in a second. So they raised 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, he's just on the board. He's not super involved. Once he finishes his masters, he gets into, you know, education philanthropy as he wanted to. He also starts this thing called TechNet, which is a...

34:37lobbying 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. So he starts that, he's running that.

34:47January 1999, a couple of things happen. One, there's some, 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 tech net. 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.

35:12He basically just shows up and announces like, okay, now I'm gonna be co-ceo with Rand off here and Rand off is apparently not super happy about this, but like, you know, the company's growing, so...

35:24and Read is great, so like everybody kind of gets along. And they initially divvied up that Randolph's gonna be in charge of marketing and content acquisition, and Read is gonna be in charge of engineering and ops. This is where Read 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.

35:46and they start having a company-wide metric around what percentage of the long tail of the DVDs are we actually successfully managing to get people to use their, use one of their slots on. Yep. Yep. Obviously, we'll get into the Netflix challenge way later, but this is really when it starts to become really in a lot of ways pioneering modern data science and data engineering.

36:08Yep. And remember, they're still in Santa Cruz in Scots 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 gonna go bankrupt. So the first thing that the board and Reed and Mark think is like, We said, maybe we should just sell the company. Do a quick flip here. 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. 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.

37:04which I assume must have been right around the post money for, 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. We're realizing that that's not super core to our subscription model. How about we...

37:29give you that. So whenever anybody on any Netflix customers want to buy DVDs, we'll just kick them over to Amazon to buy DVDs. And in exchange, I think this happened to me once. Oh, really? I'm now like, we're calling. It was in that era of Amazon doing these weird partnerships like when. Yes. Toys over us and Target was like, yeah. Yeah. Oh, man. It's a crazy imagining Amazon today doing some gigantic, co-branded corner of their store like that. It's serious. Well, especially given.

37:59What we'll see in part two with Amazon and video. So in return, Amazon is going to advertise Netflix on the homepage. Remember, this is the era of portals. Just now the most valuable real estate in technology.

38:12Crazy so that happens on the back of that they start fundraising and as they go out to fundraise we just like okay like I'm the successful past entrepreneur here. I'm gonna take over as the only CEO I'm gonna do this company come on investors at this point need to bet that I'm gonna do it again Yeah, he also he's like and we got to move out of Santa Cruz and we're gonna 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 one-on-one 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

39:09notorious deck started in his first revision but the Netflix culture is extremely unique in the early days and 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 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 there'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

40:06You 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 within 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 at a fairness. I've always thought like the way that all this is sort of like phrase and they came up with this is so both opinionated and thoughtful and every little detail considered. Now Hastings has released the deck on slide chair and I think it might be like the number one viewed deck on slide chair. Yeah, yeah.

40:53Yeah, 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 small to a flame. Yeah, yeah, yeah, so one of the things that makes them different you see Reads personal history and and shaping reflected in this culture like as all companies right are like like my partner Riley at wave is he always says like company cultures are like reflections of pure reflections of the founder, you know, personalities and you know, Rita's a guy who was in ROTC was going to join the Marines and then instead did the Peace Corps and then you know, went to Silicon Valley and became an engineer and then a CEO and then a philanthropist like it's just all like these this dichotomy like baked in there. Very cool.

41:42In 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. We're rephrased from our last LP bonus show. How large of a percentage ownership can I have in your company? Yes, exactly. And I don't care what the tech size is. Right. He raises.

42:15$100 million, 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 super hero, who has showed up in at least one other 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 clinical 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 where Spotify did not actually issue new shares at IPO. They had a direct listing.

43:09Huge huge hire as well as several other folks They hired Tom Dylan from Seagate to run ops for the company remember ops is super important here And then together this lead new leadership team like they all kind of figure out like Sort of similar to Amazon and prime that delivery speed for rentals movie rentals when DVD rentals when you 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 mouth and organic distribution. Like when you click rent and you get, remember, this is, yeah, 1998, 1999, you get that DVD in your mailbox the next day, you're going to tell all your friends. It's funny like how archaic it feels now because now I'm like,

44:00How could it not be, you know, actually instant? But I am remembering, I think what year it was, probably 2000. It was the summer of 2008, because I was doing my internship in North Carolina for Cisco. And my roommates and I did a Netflix plan for our apartment, because 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 we'd hear about a movie from a friend over the weekend.

44:27we'd like click the button and then we were watching it Tuesday night and sometimes even Monday night. And it's funny to describe that as a magical experience, but it totally was. And this is all thanks to Dylan and McCarthy and Reed and then the rest of the company, of course, but they figured this out and they realized that this is the key.

44:47one 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 hotspots? Let's build distribution centers close to them.

45:06and get these DVDs to them as fast as possible and grow, demand, kind of organically this way, also helps them better manage. Inventory, 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 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 in the target market.

45:33I remember being obsessed and actually comparing my cue with friends. It 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 and 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 cue

46:03that I was constantly adjusting of like which movies were gonna be sent to me when and like how much did I wanna 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 how long am I gonna stay a customer? And like, both of those things like lit up my brain in 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 in the streaming.

46:31One real quick funny aside, I mentioned pornography being a big part of Netflix in the early days. Read in 2000, he gets appointed to the California Board of Education. He's like, 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 a Netflix history, but did drive a bunch of their growth in the early days. Okay, it's 2000, growth is great, everybody's high flying.

46:57High-fiving, they got an A team built at the company. They filed a go public. McCarthy is 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 burn through.

47:22the $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 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 and 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. Blockbuster is like, you seem kind of desperate. I don't think so. We're just going to crush you. Unreal. Absolutely unreal. Totally unreal.

48:17So, for the companies that made it through the .com burst, you look at Amazon, you look at Netflix, you're like, wow, they were really smart, really good capital allocators. We're super nimble, we're able to make it through this. Netflix tried to get out. They were like, look, we'll just cut our losses and go be part of Blockbuster. And again, Blockbuster are not idiots, they're really not.

48:38at 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 they're like we could spend $15 million 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 recommend friend of the show, a car over at one tree. They did an episode or a little series called Business Wars. That was about Netflix versus a 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.

49:33I mean, we'll 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 male 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 stories because they franchise the stores. So the franchisee owner of the stores, they don't want Blockbuster Online to be cannibalizing.

50:00their business. So that kind of becomes an issue in a bit. Netflix though, they're like, all right, we can't offload this thing. We're, I guess we're going to have to soldier through. So they do. This is the, 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 of months ago, they were going to go public and everyone was high-fiving.

50:28Having lived through my first two years in the working world of 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 coworkers just gone in one day and Netflix does this But this is what they have to do and the way that they did it to he called a immediate urgent company meeting They made this decision. He calls like an immediate company meeting and says 40% of you are going to be late off today and then people go back to their offices to wait and see if their manager comes to talk to them or not and harrowing totally harrowing but Managed about as well as you can and 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

51:19And this was also is interesting reading that Netflix book. The way that Barry McCarthy sort of was looking at this is we need to do this to prepare for the IPO, not only...

51:30from a cash burn perspective, like we've got, I think they ended up IPO-ing with $15 million in the bank. So they definitely needed that mezzanine round that they thought was just gonna be to let those investors buy a little extra equity. But it was really about what story were they gonna go tell the street when they were able to be profitable 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 then they needed to be to be in this.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.

52:20We'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 read 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 either spin-offs or spin-outs from Netflix. Indeed. Well, okay. The next year, May 2002, they finally do the IPO. This is still nuclear winter for the tech world, but they need the cash. They've gotten the profitability. They're like, we're just going to do it. We're going to go public.

53:07they raise $82.5 million in their IPO at a market cap of just over $300 million. 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 10% like, you know, like, oh, well, and it's not, it's not IPO-ing for $300 million. Yeah. I know. I know. Crazy. Yeah. I joke to David and I messaged last night. Like, wow, it's a really nice, uh, nice series B post. Yeah. The IPO for it.

53:36Seriously, but the business is capitalized and then, you know, they have no debt. They don't need to raise any more money and they don't, 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.

54:00So remember, Randolph, the original CEO, and Lowe, the guy who was running the video stores in Marin. Now that the IPOs happen, they're like, okay, great, we're gonna go focus on new things like initiatives within the company now. And they start testing key asks, Netflix key asks that they're gonna put in grocery stores. And they're like, this is gonna be a great new growth initiative. And Hastings and McCarthy, they're like, guess.

54:23And 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...

54:46low and Randolph's brilliant idea of like maybe maybe this is the way to solve instant. Maybe this is the way to solve instant. What? 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.

55:04And wait, wait, before they kill it, though, this is great. Low 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 start-upy. 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 this Smith's grocery store. And just like people can come in and they will just do it manually. And the employee will hand you the DVD, which is just awesome. And to oversee this, 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 still awesome. It is awesome, as we will see. But you can also understand why

56:03McCarthy and Hastings are like guys, guys. Not now. The second thing that happened before they killed it is that Low 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 Low 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.

56:37when they're waiting in line. Like that, no, absolutely not. And so part of killing it was 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 Lowe, 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.

57:03Randolph gets full time into an investing as we talked about Chubby's and look her and all that. Low, he can't stop thinking about this kiosk thing. He's like, I'm going to make this happen. He's like, I'm going to start a company. That company becomes Redbox. Which is an actual very significant competitor to Netflix. Yeah. I actually don't know what's happened to it now. Does it still exist in the streaming world?

57:31I think it is now part of something called outer wall, which is their own red box coin star, ecoATM, 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 coin star was in Bellevue.

57:54Yeah, yeah, yeah, I think maybe coin star expanded to become outer wall when it rolled up all this other stuff something like that But red box is now part of that that private equity family. Yeah crazy All right listeners now is a great time to thank our longtime friend of the show service now if you are running a large enterprise AI agents are likely spread across every team and deploying them is no longer the hard part Yeah, the hard part is knowing what permissions they have, what employees are using them for, or what decisions AI is making. AI security for an enterprise at scale is not a small concern, like the risks are real. Exactly. And the challenge with AI is governing it, securing it, measuring it, and making sure that it actually delivers value. That is why ServiceNow built the AI Control Tower.

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59:43So if you're trying to turn AI ambition into real business outcomes and make it work safely, securely at scale, go check out servicenow.com slash acquired and tell them that Ben and David sent you. 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.

1:00:12I 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 you know, 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 launch blockbuster online. The week that they launch blockbuster online.

1:00:32to the general public, Netflix market cap drops 60% in one week, like a rock. And as we said, it actually becomes a pretty good product, plus they have all the marketing power of Blackbuster. And so what happens is very quickly, all of the market 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.

1:00:59Blockbuster 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. And if you think about that...

1:01:11the timing on this. So when Netflix IPO they had 500,000 subscribers. It's interestingly not that big of a number on the number of movies. It was 11,500 movies that 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 two hundred dollar dvd players america is buying dvd players are bet was right this is just fueling our business this is amazing timing and so for blockbuster to just nail it and and and launch it exactly this time is like kneecapped at this this uh... million subscribers that they have up from five hundred thousand i p o is

1:02:02there's what 200 million households in the US or something like that, anything that happened before is irrelevant and what matters now is news hindups in the future. Yeah, exactly. Not only does that happen, they've got a second problem which they're even more worried about, they get word that Amazon, and their one time potential acquirer is going to come into the market and is working on building an Netflix competitor. Remember, not streaming, we're still in the DVD rental market.

1:02:30They 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 an quote on the on the investor analyst call.

1:02:46You don't leave your friends in the middle of a knife fight. It's just awesome. What a hero. And he literally like swashbuckling comes rides back in. In anticipation, not a blockbuster, not a reaction to blockbuster, but in anticipation of Amazon coming in because I think Amazon's gonna follow the Amazon Playbook and just undercut everybody.

1:03:09price. 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 now blockbuster and Netflix get locked into a price war and blockbuster further undercuts Netflix and things go like, hey, why are 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.

1:04:00Well, they can in the gant, as we'll see. So McCarthy and Hasey, they're like, okay, we need to model out exactly because Netflix has a bunch, Blackbuster has a bunch of debt 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.

1:04:20what 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 cash cycle here, yes, there's a bit of million subscribers acquired. They hope to acquire another 100 million in the future.

1:05:15They're dramatically accelerating market expense 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.

1:05:32to get nothing for that first month. So it's like, you know, 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 that looks like, oh my god. 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.

1:06:00Because we will see here, if Barry McCarthy is the acquired superhero, the acquired super villain steps into the scene here, Carl Aiken. Of Marvel fame, of where else has he showed up in our episode so far? I don't think we've talked about. Maple is with Apple with like this guy. Oh my god. Hedge fund billionaire. Activist shareholder.

1:06:26he gets super involved with Blockbuster. He buys about a 17, either 17 or 19% stake on the public markets in Blockbuster starts agitating files, a proxy battle 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, I can just like, replaces the whole board with like I can 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. It's insane. It's insane but for the black master management they manage to kind of like keep things on track and they decided with all this going on they need to raise prices back up so Netflix and black master both raise prices back up.

1:07:20The tide is rising. Both companies are co-existing here in the market. Things go pretty well. Netflix is still the leader. They end 2005 now. They have over four 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 part two, but super awesome. Get a ton of PR. Can any brilliant computer scientists out there?

1:07:49Beat our algorithm by was it 10%? 10% yeah, 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 prices 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-2000s they really need to go all in, management decides online. And they think, 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, which 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 extra that you get is

1:08:47You 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 Amazon Go and Prime Now and this is actually pretty visionary. It's risky because it does involve a lot of capital, a lot of ops. People are very skeptical that this could work, but if it does, Netflix can't match it. They have no physical footprint and blockbuster as 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, well, and they get scared, it actually makes a huge impact. So Netflix growth flatlines not only to really stop growing, they start losing subscribers. This has never happened. Like, remember, they've just been

1:09:37Adding 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 And they're so worried Sundance 2007 read Hastings meets with the blockbuster CEO and he offers essentially a merger of the two companies and he says Netflix will buy blockbusters 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, I can.

1:10:28Oh 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 Lincoln and the blackbuster 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 this amount.

1:10:54I can then hire a new CEO this dude from 7-Eleven, who this guy... And to be clear, this is icon 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's 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 gonna beat them. And the...

1:11:23This guy who Karla can brings in I don't even remember his name. It's not worth it Basically like we try to be pretty even and balanced unacquired 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, I think, Google has been public for three years, like, you know, this is insanity. He doesn't believe in online businesses. He, his plan.

1:11:53He's gonna totally defund blockbuster online. He thinks Netflix is a joke. Nobody's gonna do it. He wants to bring back the heyday of bricks and mortar. He wants to make bricks and mortar great again. 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.

1:12:18God, if you were real Hastings, it's like you, this is like a gift from heaven. Have your jaw drop and be like, well, 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 Fund 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.

1:12:46This new CEO of Blockbuster, he's like, we're gonna buy Circuit City for a billion dollars. You literally cannot make this stuff up. You know it's better than one 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 ridiculous.

1:13:09Everybody, it doesn't actually happen because even Carl Lincoln is like, I'm not sure that's a good idea. Have you been to one recently? Yeah, so... Basically, everybody good at Blockbuster, who was running the online business, they just resigned. 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 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

1:13:49Momentum, 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.

1:14:18They're on the top of the world. It's amazing. And that is where we're gonna 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? I'm really glad that we, uh, this feels like such a good place to, to hang. Oh, totally. I just like.

1:14:47Circuit City. Circuit City. I mean again, like the worst, the worst. 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 S1 last night because I think they're interesting. So they sold 27% of the company in this IPO raised $82.5 million.

1:15:14no 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, which will get diluted down to about 15% after the IPO. TCV, technology crossover ventures, in two different vehicles, I'm pretty sure I'm reading this right, has 46% of the company. Yeah, crazy. Pretty rare to see that at IPO.

1:15:42a single firm with a different air ownership. Totally different era. You look at what they did there. They were able to raise, you know, I think in that, including that second little offering, close to $100 million, 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 talked 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.

1:16:28unlike other times, like Facebook or like the snap IPO, it's not like there were people running 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 IPO-ing 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 what was there.

1:16:56It was one of the only tech companies because people just watched all these comms go bust. It was one of the only tech companies that was posting 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.

1:17:13Yeah, people are just still so, you know, human psychology. Hangover from the IPO crash, they're like, this CEO was the largest merger in Silicon Valley history in the bubble era. 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. You know, hard to know. But yeah, the bookcase, like you said, like, this is a good business.

1:17:43subscription businesses. They could be a thing. If they work, if you can get them to work, they can be very challenging to scale. But this is why cable companies are so good and cable companies will come back up in part two of the episode. If you can get consumers locked in to 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?

1:18:13Let'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 it. Yeah. If they hadn't opportunistically raise some cash right before they thought they were going to 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 properly fight blockbuster. If they didn't do the 40% layoff, like, yeah, just a lot of things went their way here. Companies, it's 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.

1:19:05That 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. The first one that I'm thinking of is like...

1:19:21And we've beat this to death on this episode, so it's not going to be surprising to anyone. But Tabula Rasa, if you come up to me and said, what wave did Netflix take advantage of to really launch them as a company? I'd be streaming. But the fact that DVDs were a wave is still a little bit mind-blowing to me that 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.

1:19:48Totally 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 of Netflix and well foreshadowing quickster. They really are two different businesses Did you know you can still go to DVD? Actually, they bought the domain Netflix has DVD dot com. Oh, no, we can go and access their DVD offering there Huh 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 blue rays. What about Dibbix? Duffle. Duffle. Okay, I have a couple. The biggest one though, we, we glossed over a lot of stuff as we had to in this story. This is part of why we're doing our LP program and bonus services to get deeper into like,

1:20:47Who are the people that actually build these things? And one of the decisions along the way that operationally helped 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.

1:21:13Barry McCarthy, Joy Covey at Amazon, Leslie Kilgore, who ran analytical marketing and Netflix. We didn't get to talk about her, but there are so many people that are just really, really, really good. They tended to come from the CPG world, 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 in Amazon, a bunch of these folks in Netflix, and they're just so good. And I feel like that's like...

1:21:41That'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, but cowboy market. Yeah, it's become so cowboy and it's become also just so dependent on Google and Facebook. Like although the good growth people would find ways and tell you that their way isn't right. There are still good people. But you know, this is the Barry McCarthy modeling out Netflix's online business to a tee like he knew what month they were gonna have to raise prices the Netflix program with consumer manufacturers of consumer electronics manufacturers to put the coupons in the boxes and modeling out exactly what was that was gonna cost exactly what their growth rate was gonna be you know the going population and not subscriber center by subscriber center with the with the one-day delivery being driven by where

1:22:34word of mouth is occurring, all that stuff. That's the company building stuff that built Netflix into 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 that I call out is the shift to viewing in-home instead of in theaters.

1:23:03And 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 was like, look, no matter how people are renting movies, like they're watching them at home. And that's really helpful for us.

1:23:32which I thought was interesting. And the other that they cited was in 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 your mad that there's not enough selection or the movie that you want is out.

1:23:47Okay, if you go anywhere where there's infinite selection, then 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 S1 to shareholder, which was interesting. And I've got a few more, but we're going to save those for part two. All right. Should be great. This we're going to grade the IPO here. Yeah.

1:24:17So I was thinking about this and I'm like, okay, let's say they didn't because we've already covered like 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, why IPO? What's the point of that? You've got the cash position they're sitting in as 15 million in the bank. They're not going to be profitable this quarter, but maybe the next it is 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

1:24:52more leverage with content providers, which isn't really a huge factor in their business yet, but there's some element of buying, you know, they're already buying DVDs in mass, so they sort of 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.

1:25:15So that gets you more and better content, which then makes you inherently that improves the product offering, which then lets you go get more customers. And so 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.

1:25:40good move, I mean, it's not like they could have raised anymore, 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 wise 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...

1:26:10One thing I wanted to add on to the flywheel aspect, we thought about this a lot at Rover actually, 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.

1:26:34where 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.

1:27:03Once that happens, you can super quickly go from like a cash burning business as we saw it to like an incredibly immensely profitable, immensely big mode. 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. Now, Blockbuster could credibly do that. Amazon could credibly do that, but nobody else could. And once Netflix did that, that's when...

1:27:29As far as the DVD business concerned, oh, it's concerned. 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 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.

1:27:48Certainly A range because they needed to, they executed, it was great they did what they had to do. Just the market conditions were so bad, like selling that much of the company, like, you know, 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. Carvouts? Carvouts. Okay, so mine, I'll go quickly. I can't believe it's taken me this long to read and then recommend.

1:28:15NK, 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.

1:28:42and 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 can save the world, but they're persecuted and like so you have to give it. 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.

1:29:12that I've been watching called The Good Place. And it's with Kristen Bell. It is really goofy, but really good and really good sort of just like popcorn, you know, watch it for a half hour before you fall asleep. It's basically like a heaven and hell thing where Kristen 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 and cheek, but Really good. And when I picked it, I didn't realize that it was an Netflix show, but Netflix original content coming soon in the next episode. Awesome. All right, listeners. Now is a great time to talk about one of our favorite companies, Statsig. Yes. There is a reason why the best product teams rely on Statsig, whether they are iterating on their core product features or shipping AI-powered experiences at scale. Yep.

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1:30:53If you like listening to acquired and you just want more or you want to help us support the show and and make it even better and somehow we just keep doing more deeper research and I've been super super excited about the guests we've had on so if you want to help us do more of that you can become a limited partner so go to Kimberlite.fm that's K-I-M-B-E-R-L-I-T-E.fm slash acquired or click the link in the show notes to join. Thanks everyone and we will see you next time. We'll see you next time with part two.

1:31:23you