How Netflix Innovates and Wins

Goldman Sachs upgraded Netflix from neutral to buy on Tuesday, setting a $300 price target.  The news drove Netflix shares up almost 8% to $217.11 and a market value of more than $11B. The market is richly rewarding Netflix for being on the cusp of achieving Netflix CEO Reed Hastings’ vision to stream movies over the Internet directly into people’s homes. What Hastings should really get credit for, though, is the diligence with which he prepared the way for his vision—and that method is one that others can emulate.

Netflix illustrates a design principle that any company aspiring to succeed at disruptive innovation must adopt. It has four parts:

  1. Think Big
  2. Start Small
  3. Fail Quickly
  4. Scale Fast

Even as he built the DVD business that toppled Blockbuster, Hastings was guided by the big idea that mailing people DVDs was a mere way station on the road to streaming video. As far back as 2001, Hastings spent $10 million a year on research into streaming; he was willing to forgo most of his tiny company's profits to get started on his preparation. In the years since, Hastings has frequently set up small tests to offer streaming video—only to junk the projects quickly when he realized they weren't feasible. As streaming started to become real, Hastings did a host of deals with content providers to see which would work and to make sure he wasn't left out, even though it was clear that most of the deals wouldn't amount to much. Hastings also considered numerous pricing models for streaming, ultimately deciding to start by giving it away as part of DVD subscriptions. That way, people could get used to streaming while he built his library of offerings, and he wouldn't create an opening for a competitor.

In late 2010, after almost 10 years of experimentation, Netflix offered a streaming-only option for about half the price of a subscription for DVDs by mail. That pricing—combined with the increasing size of the Netflix library, the spread of broadband connections, and the seemingly universal adoption of video-friendly tablets and smartphones—drastically accelerated the move to streaming.  In its recent annual report, Netflix said:


The Netflix success may seem straightforward. Just about everything looks simple, even inevitable, after the fact. But executives need to truly understand the elements of the Netflix success if they want to emulate it and must have the discipline to follow each of the four steps that Netflix followed. Historically, few have.

Think Big. Hastings pursued his big idea, streaming video, even though it would render obsolete his wonderfully successful, highly tuned, mail-based system for distributing DVDs. By contrast, most companies think small—they try to protect their existing business even if they can see a long-term threat from the Internet or other technological disrupter. Companies that sell products through a network of agents protect the agents. Companies that sell goods through a chain of physical outlets protect the outlets. Companies that sling newspapers onto doorsteps try to protect the paper form of their information. These companies tell themselves they’re making incremental improvements, only to wake up one day and find the world has changed. When that day comes, they switch to panic mode, as Blockbuster did once it realized Netflix had transformed DVD distribution. Panic almost always leads to a huge, but ill-considered, bet—and failure. (For a chilling post-mortem on numerous ill-conceived big ideas, and how to avoid making the same mistakes, see my recent book, "Billion-Dollar Lessons," co-authored with Paul B. Carroll.)

Start Small. Though Reed Hastings had a big idea that he fervently believed in, he started with lots of small projects.  On the contrary, companies with big ideas tend to fall in love with them and rush headlong into making them real.  Take Starbucks’ failed launch of Sorbetto.  It was an icy drink that Howard Schultz, Starbuck’s CEO, thought would be his next Frappuccino.  Schultz had recently returned to the Starbucks helm and desperately wanted a product to boost sagging sales.  He trusted his instincts and rushed Sorbetto into a splashy, 300-store launch in California.  But, as reported in the NY Times:



With his more recent launch of instant coffee, Schultz learned his lesson, started small and worked out the kinks before going national. The Times says he may have a major success on his hands.

Fail Quickly. When early efforts at streaming video looked iffy, Hastings adopted the poker player’s mantra that most money is lost early in a hand, when the tendency is to hope that something good will materialize even though reason suggests otherwise. Hastings folded his hands, saving his money for the day when he finally got a good hand. By contrast, most companies keep playing bad hands far too long, partly because those involved know they’ll get tarnished by association with a failure. As one client bemoaned to me,


Scale Fast. Netflix is now scaling streaming video fast, maintaining the lead it worked so hard to build over competitors. Numerous companies have, however, won early battles and lost the war at this stage of innovation.  Magical innovations are successfully developed but never find a home because, unlike Netflix, the company isn’t willing to attack its core business.  One of the most dramatic examples is Kodak, which invented the sensor at the heart of digital photography in the mid-1980s, but, for decades, never found a way to leverage it.

It’s worth noting that Netflix is still very much a work in progress. Newspapers are reporting that the company is in talks to buy the rights to a television program, which would put it in direct competition with networks and perhaps accelerate the trend toward what is known as “cord cutting”—ending a monthly subscription to a cable-television or satellite-television service and drawing content directly from the Internet via Netflix or other service.

In other words, having savaged the movie business, Netflix may now have television in its sights, and the company seems to be taking the same smart, disciplined approach that has stood it in such good stead thus far. The company is thinking big but starting small. Failures, which will surely occur, will likely be quick. Scaling, if Netflix ever gets to that point, will surely be breathtakingly fast.

Please share your thoughts on systematic innovation.  What's harder: thinking big, starting small, failing quickly, or scaling fast?  How good are companies in putting it all together?

Follow me on Twitter @ChunkaMui