Very few digital media upstarts have been able to build scale businesses in online entertainment. No startup has succeeded at scale in digital music (with only Apple and, barely, Amazon registering any level of success — these are hardly startups). In online video, clearly YouTube reached scale (but had no meaningful business) when it was acquired by Google and now, with Google’s help, will clearly reach scale as a business. In online movies/TV, of the “Five Guys” who seem poised to be meaningful (Apple, Google, Microsoft, Amazon and Netflix), only one is a startup, and it sure is an outlier. And an amazing outlier they are.
In examining how Netflix successfully navigated the perils of licensed entertainment content businesses, important and familiar lessons emerge.
The movie studios wanted Netflix dead. They hated the model from the beginning. Only problem was, they couldn’t kill them. Thanks to the first sale doctrine, codified in copyright law, a lawfully purchased DVD could be rented. So, when many of the studios didn’t want to play ball with Netflix and offer them discounts (or even wholesale pricing) on DVDs, Netflix just went to the store to buy them at retail. This allowed Netflix to get off the ground and assess market demand for their DVD-by-mail rental business without any approval or licenses from rights holders. CEO Reed Hastings’ gut proved right — a more consumer-friendly model of no late fees and big selection overpowered the immediate convenience of going to a corner store to pick up a movie for a night. He offered a better service for consumers against the strong will of the rights holders. And by building a great product, he was rewarded with massive consumer adoption. There are more than 15MM subscribers today, and growing.
Many analysts predicted the death of Netflix as the world shifted from DVD viewing to on-demand streaming. It wasn’t that people believed Netflix couldn’t develop a compelling streaming service. Many of us thought Netflix would whither because the studios/networks would never license them content on reasonable terms. There is no first sale doctrine in digital goods, so Netflix could not get into the streaming business without negotiating painful voluntary licenses with each rights holder. The studios had begun licensing services like Amazon’s Unbox, Apple and Microsoft with limited titles loaded with consumer unfriendly restrictions and pricing (movies can be rented for $3.99 or $4.99, must be watched within 30 days, and once started, will expire and become unwatchable after 24 hours!) Reed Hastings, with 15MM subscribers and growing knew those terms were largely a non-starter with the mass market. He had built a huge business based on customer convenience — pay once a month, watch as many movies as you can, and NO restrictions! Keep a movie as long as you want!
So, it seems Netflix could either stay out of the streaming business or license limited content like everyone else with lots of restrictions. And this is where Netflix beat the odds. They knew the two main weaknesses of studios and networks: (1) big money talks — they are motivated by short-term profit and (2) the profit participants (directors, actors, writers, showrunners) will exert pressure when big offers are put in front of studios/networks.
As Netflix grew in size, an interesting thing happened — they were massive patrons of the postal service by spending a few billion dollars a year on postage. They reasoned they could simply shift that expense to content owners and have as good or better a business. When they waived a $1B check in front of the studios eyes, suddenly all those restrictions on pricing and limited viewing went away. Netflix used some great negotiating savvy to offer really big numbers to studios in total, but also big per-episode and per-movie-title guarantees. This allowed the profit participants to put pressure on the studios/networks to take the deal. Because Netflix can influence the shows we watch, they can afford to overpay on a per episode basis for hit shows to help with customer acquisition, but can steer us to lower-cost programming once we become members.
In short, Netflix developed great economic leverage with the rights owners — and that is the only way to force them to do deals that allow both customers to be delighted and also leave enough margin for startups to build a business. Without the first sale doctrine, however, Netflix never would have gotten there. And once they got leverage, they played their cards perfectly.