Why Netflix is killing it — and what startups can learn from its success

Netflix just became the number one provider of subscription entertainment content in the United States, with 22.8 million subscribers. Comcast now comes in at number 2, with 22.76 million. And the trend lines indicate that Netflix will continue to grow.

In the process, Netflix has eviscerated Blockbuster and fought back an attempt at its space by Wal-Mart. Netflix shareholder returns far outpace Google, up 2800% since inception vs. 380% for Google.

How did Netflix do this?

Not getting too far ahead of the market. This is a mistake many entrepreneurs make — looking around at their needs and the needs of their friends and building for them. That’s great if your product is targeted at the Silicon Valley geek market. Not so much if you’re trying to reach the mass market.

Only 14 years later is Netflix offering streaming only plans in the U.S. But the dream has been there since the beginning. (The company isn’t called DVDFlix.) Reed Hastings was smart enough to realize that DVDs were an important transitional technology and Internet delivery wasn’t something that would work in 1997.

If you’re building a mobile product for small businesses and you require that everyone have an iPad, you’re asking too much. Think about whether you can accomplish your goals with email, SMS, voice or even fax.

Sharpness of focus. The market for video entertainment has a lot of players, each with its own twist. There is free content (YouTube, Vimeo), purchased movies and TV (Amazon, iTunes), ad-supported TV and movies (hulu, various network sites), new-release movies (cable pay-per-view), Redbox. Netflix could have gone in any of these directions and tried to compete aggressively for them. But it hasn’t. It has focused on a low-price subscription service featuring premium content.

That focus keeps the company from chasing every shiny new object — which has been the downfall of many startups.

Aggressive acquisition marketing. If there’s a better acquisition marketing company out there, I don’t know who it is. Netflix advertises across a variety of media, including search, online display, partnerships (e.g. airline miles programs), print, direct mail and TV. As successful as AOL was in the 1990s, Netflix is now. About the only thing they haven’t done is carpet bomb mailboxes with free DVDs.

A key to being successful at acquisition marketing is having tools to analyze performance by channel — key metrics like acquisition cost, ARPU, average customer lifetime and churn rate. If you know these numbers, you can make better media buying decisions and use that to grow your business.

Another important part of Netflix’s success is keeping the offer simple. If you haven’t done it recently, go through it. There aren’t six different plans to read and understand. Netflix picks a likely one and tries to get your credit card as fast as possible. The only plan-related question I found was “Do you want DVDs with that?” When faced with a lot of choices, many people will choose to do nothing at all.

Aggressive A/B testing. Netflix A/B tests everything, including pricing, features and user interface. I wrote about a Netflix test of its streaming only pricing before it was released as a new product.

Traditional methods of market research like focus groups and user surveys work OK if it costs you tens of millions of dollars to retool production lines. But they have many problems:

  • Users don’t always act like they think will act.
  • Some people will say what they think you want to hear.
  • Users are incredibly bad at estimating their own usage. (Every time I’ve asked users how many times a week they’d check movie listings, inevitably about 30% of them say they would check daily.)

In the online world, it’s easy enough to test variations based on real users. Let data, not egos, make decisions.

Not being held hostage by power users. Netflix hasn’t gotten as far it has without some controversy. Power users complained about issues such as throttling and deals that delayed availability of some new releases for 28 days. Many also complained about the removal of social features. There will always be requests for more features.

Yes, Netflix could have done things to placate these users. But those would be expensive and detrimental to the vast majority of Netflix customers.

The best example of a Web company that fell into this trap is Digg. A small cabal of users controlled the site experience. By the time Digg got around to fixing this, Twitter and Facebook had displaced it as a leading news source.

There is always the temptation to add power-user features under an “advanced” tab. Don’t do it. It will cost you in consumer confusion, team focus and support costs.

Relationships. Many in the technology world think that Hollywood is backwards and that all they have to do is build better technology. But that won’t matter without content to flow through that technology. Netflix, more than most companies in the space, has spent time building relationships with Hollywood.

Studios have learned from the mistakes of the music industry and haven’t been taking the sue-first-ask-questions-later approach. (Unless you’re egregiously stealing content.)

Unlike some in the industry, Reed doesn’t go around aggressively thumbing his nose at studios and cable companies.

Distribution everywhere. It’s getting harder and harder to find a consumer video device that doesn’t come with Netflix. You can get Netflix connected to your TV almost by accident. Blu-Ray players, video game consoles, dedicated media streamers, iPhones, Android phones, iPads, Internet-connected TVs. Even products from companies that are directly competitive with Netflix, including Apple and Google, offer Netflix streaming.

Consumers electronics is a notoriously low-margin business with a lot of risks. Netflix had a device team in-house, headed up by ReplayTV creator Anthony Wood. Staying on focus, Netflix never launched its own device. But they worked closely with Wood at Roku, who will sell you a box that streams Netflix for as little as $60. (See this deeper discussion on Roku.)

Instead of competing directly with consumer electronics giants like Sony, LG and Philips, they helped a company show how Netflix streaming could be done. And Netflix has managed to do this without expensive SiriusXM-type device giveaways.

Shaping demand. One thing that Netflix rarely gets credit for is the degree to which it can shape demand. Netflix has successfully changed the value proposition for Web video from “any movie, any time” to “something entertaining, any time”. This is a great 90% solution that results in lower costs and happier customers.

Looking for a movie that isn’t available on Netflix streaming but is on DVD? Netflix will suggest alternatives that you can watch right away. If you agree, Netflix just saved about 95 cents and you are happy because you found something to fill that time. In theory recommendations for streaming movies could be based on operational factors, with utilization-based content shown below content with an unlimited license.

Operational efficiency. Netflix spends about $600 million a year on postage. That number would be significantly higher if it weren’t for a recent invention called “Permit Reply Mail”. It’s a category of mail that I’ve only ever seen used for one purpose: returning DVDs.

In the Business Reply Mail category typically used for postage-paid mail, the recipient pays a premium because each returned mail piece needs to be accounted for. This arrangement works because only a small portion of direct mail gets returned. With Netflix, the return rate is close to 100%. With Permit Reply Mail, Netflix prepays the return postage.

The lesson for startups here is to work with your partners to figure out ways to reduce costs. There may be things that you could do easily that would eliminate a step that’s really hard and expensive for them or vice versa.

AOL offers an interesting comparison to Netflix. Neither company owned the content or the pipes that delivered the content*. But Netflix found a way to create experiences that strengthened its consumer relationships. At its peak in 2002, AOL had 26.7 million subscribers. As AOL’s paid subscribers asymptotes to zero, Netflix is poised to surpass the 26.7 million number before the end of the year.

* Technically, the combination of AOL and TimeWarner did also own content and distribution (at least within the Time Warner Cable footprint) but they never acted like one entity.

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About Rakesh Agrawal

Rakesh Agrawal is Senior Director of product at Amazon (Audible). Previously, he launched local and mobile products for Microsoft and AOL. He tweets at @rakeshlobster.
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