CASENI

N etFlix.com, Inc.
In July 2000, Reed Hastings, chairman ,md CEO of NetFlix.com, Ine., faced a criticaI deci:;jon.
Thrl'C months earlier, following one of tl1l' worst episodes O!l record for the NASDAQ market,
NetFlix had submitted it:; 5-1 filing for its initial Pllblic offering (Iro).! A:; il rl'sult of thl' market
downturn, many Internet companies had been forced to withdraw their 1['0s. Invl,:-;tment bankers
indicated to Hastings that NetFlix would 11(.'Cd to show positive cash flows within a twdw-month
horizon in order to have a succes.,,,flll offering. Hastings knew that NetFlix was at a crucial stage.
With revenU($ doubling evcry six months, NetFlix was enjoying tremendolls stlccess. But continucd
succcss depcnded on thl' company's ability to sustain triple-digit growth (or the fOfesceable future.
Soon, Hastings would have to decide whether or not to proceed with the company's anticipated IPO.
Hastings askl..'\l Barry McCarthy, the chicf finnnciai officer, to re-('vnluate the cash flow
requircments of thc company's currcnt business pian, to suggest modifictions that would improvc
the company's projected cnsh flows, and to makc rccommcndation on whether the company should
go forward with its plnned offcring. As McCarthy rcviewed the existing NetFlix business model, hl'
considered possiblc chnges that might allow thc company to procccd with its planncd IPO nd yet
sustin thc typc of futtlrl..' growth that would be nccL,:-;sary for thc compny to achieve its long-run
objcctivcs. McCarthy was acutcly aware of thc company's currcnt financing m't'd, but he worried
about thc cffect tht changes to the business pian might hnve on thc company's current operatillns.
TheCompany
NctFlix.com, fne. was founded in 1997 by Recd Hastings nd Mrc Rnndolph. NctFlix opcratcd
n Internct-bscd unlimitcd rcntal subscription service for digitl video disc (DVD) formattcd
movics. The DVD providcd ncw technology for storiog nd playing movies with image and sound
qUlity cxceeding tht of traditional vidcocassettcs. A DVD was similr in sizc to an audio compact
disc and was capablc of holding no cntirc featurc-Iength film, as well as additional information such
as subtitles in diffcrcot l'lI1guagcs, additional shortcr vidl..'oS about thc mking of the film or othcr
rclated subject mattcr, and information about thc lctors, director, nd produccrs. With its high
quality and dditional fcatures, thc new DVD tcchnology provided an ttractivc altcrntive to
traditional vidcocasscttcs for thc home video market. By combining thc supcriority of the new DVD
I After r.,aching il hist{lrical high {lf 5,(148 on March lO, 21XlO, th., NASDAQ Composite Index h" fall.,n 25'1.. tu 3,794 by
April 18, 2(XJO, the day of the Nctl-'Ix S-1 filing.
NeIFlx.com, Inc.
tL'Chnology with the convenience or the Internet, NetFlix provided il new way to sclect and to rent
home movies.
Rnndolph nml1nged production of the NetFlix web site, inclllding the featurcs, fllnctionality, and
contL'nt on the site. Randolph bdieved that conSUn1ers were often frustrated in their dforts to scll'ct
and view movies nt traditional video storcs because of limite..i sclections and il focus on new rdense
movies. With its unlimited "virtual" she\f spnce for stocking videos, th ..' NetFlix wcb sile focuscd on
improving the experiel1ce of sclecting <l movie to watch by providing an intelligent interf.1Cl' lor
browsing, sL'<lrching, and l'valuating potentinl movies. l'hl' NetFlix wl'b sile also integr.1tl'd movies
currently showing in thmters by providing thl' ability to check local Jistings and show times, as wdl
.1S the ,lbility to view movie trailcrs 011 its web site. In addition, the NetFlix web site kept track 01
each subscriber's prderl'nce for various types of movil's alld provided an individualizl'd pn'dkted
ratillg for ali of the movies on the web site.
Since lnunching its web sitt> in AprilllJ98, NetFJix hnd l'xperienced rapid grnwth. had
grown from $1.4 million in 191.)8 to $5.0 million in 1999. The number of full-time emplllyees inCrl'<1scd
from 46 in Dccember 1998 to 270 in DeCl'mber 1999. By March 31, 2000, NetFlix had ovcr 120,000
paying subscribcrs. Typical of most Internet startups, however, Nl'tFlix had not yd l'nrncd a profit,
reporting net losscs of $11.1 and $29.8 million in 1998 and 1999, rcspectivcly. Exhibit 1 and Exhibit 2
pmvide annual financi'l\ st'ltements for 1998 and 1999. Exhibit 3 provides quarterly opcrating results
for 1999.
The NetFlix business model focuscd exclusively on the new DVD formnt technology.
Mnnngcment had four main reasons for focusing on this spccific scgment of the home video market.
DVD players were the fastcst growing segrnent of the vidco playcr market. &'C<luse of the
capid adoption of the ncw DVD technology, salL'S were forecast to grow ilt a 49'1., compound
nnnuai rate over the next five years.
2
Exhibit 4 provides 'I comparison of DVD player and
vidcocassdte recorder salcs during the ficst five yenrs 'lfter their respective introductions.
Becausc of their small size, Iight weight, and durability, DVDs could be distributed to
subscribcrs on a cost effective basis via reguInr U.S. mai\. Induding thc costs associatL-d with
processing thc order, McC'lrthy estimated the round-trip cost of shipping a DVD to il
subscriber and back to NctFlix to be about $1.00.
In order to promote salcs of DVD players, manufacturers were willing to include NctFlix
promotional offecs with their packaging materials at essentially no cost, which allowed
customer 'lcquisition costs to be kept to 'I minimum. Management h<1d negotinted agreements
with most of the leading DVD m'lnufacturers, including Sony, Toshiba, Panasonic, and RCA.
These rnanufacturers accounted for over 90'jI,} of the DVD players sold in the Unitcd Stntes in
1999.
Management believed that ear\y adopters of DVD L'Chnology were likcly to have a computer
with an alrcady existing internet connection and were likcly to be willing to conduct
commerce over the internet.
2 l'mll Kagan Associates, Inc., as dtcd in NctFlix 5-1 filing.
2
NeIFlix.com,lnc.
linstings vicwcd NctFlix ns a combination of a traditional video StOft', such as Blockbustcr or
Hollywood Video, and a subscription cable TV scrvice, sllch ns HBO, Cinemax, or Showtme. By
paying a singlc monthly sllbscription fee ranging from $15.95 to $19.95, a NctFlix subscribcr could
rent an lInlimited nllmbcr of DVDs cach month nnd coulti keep a DVD ilS long as desired. 3 BeGll1Se
NctFlix diti ilO! impose a spedfic datl' on which a DVD was to be rctllrned, slIbscribers did not h<1Vl'
to worry ,1bout paying atiditional k'L'S for videos that werL' rcturnet late. In ordl'r to attract new
slIbscribers to the NctFlix web site, NctFlix distributcd COUpO!1S l'or a fl'eL' month of Sl'rviCl' with nL'W
DVD players. The costs associ,lted with tlwse fret' ll10nths of SL'l'vicL' to new subscribl'rs ll1adl' up thc
t11ajority of snlcs and Il1nrketing l'Xpel1Sl'S. In '199<') illone, NetFlix recordl'd over $16.4 million in snles
,md marketing l'xpense.
Once a subscribl'r hnd signed IIp for tlll' frl'l' ll10nth of service, the Objl'ctivl' wns to gl't the
sllbscriber to convert from frl'e- to paid-statlls and then to retain that sllbscriber for as long as
possibk'. In order to study the dfect of the sllbscriptol1 fee on cOl1vL'rsion and rl'tcntion l'all's,
milnagel11l'l1t had testL'd a variety of different pricc points. Bascd on analysl'!' of data l'rom these
market tests, McCarthy bclieved that his comp<1ny's ability to retain subscribl'rs W,lS comparabk' to
that of sllccessflll subscriptiol1 cable services. McCarthy estimated that approximately 70% (lf new
subscribers converted to paid-status and that 40% of subscribers th<1t converted to pilid-statlls
continued to subscribe after six months. McCarthy expected rdention rates for subscribers that
subscribed more than six months to be quitc high.
m'cause the NdFlix business model focllsed on the acquisition ilnd rctention of individuai
subscribers, McCarthy projected future NetFHx financing requirements lIsing a subscriber mode!.
Pirst, McCarthy modeled the expected cash f10ws from a newly acquired sllbscriber, including the
subscription fees paid, the cxpected oumbcr of discs rented, the costs associated with shipping and
disc ncquisition, ilod any other cash flows that varied directly with the ilcqllisition or loss of an
individuai subscriber. Sccond, McCarthy modcled thc Iikelihood that any given subscriber would be
rctained over the forecast hori:wn. And last, McCarthy uscd the projected number of future new
subscribers together with the numbcr of existing subscribers to fon'cast the compill1Y's ('xpccted
aggregate cash flows.
The Marquee Queue
A key aspect of the NetFlix business model was the "Mmquee Queue" concept. TIle "Marqllee
Queue" allowed a subscriber to have several movies 00 hand for viewing at ali times. A subscriber's
queue was simply a Iist of ali thc movies that the subscriber had sclected, but which had not yet been
sent to the subscriber. After logging on to the NetFlix Web site, a new subscribcr would browsc the
virtual aisles and sclect movies that he or she wanted to watch. These movies wOllld be uscd to build
the subscriber's queue. The NetFlix web site made it easy for the subscribcr to edit tlle qlleue, such
that the list could be arranged in the desired order. NetFlix would then ship the DVDs at the top of
tlle quelle to the subscriber.
3 Since launching its Web sile, management had tested il variety of different prcing l'lans. l'rom February !l)'!'l throu!:h
Octobcr ll)'!lJ, NetFlix genemted most of its revenues from individuaI DVD rentals nnd .1ssociated shipping chargcs. In
Scptember 1lJ<JlJ, NctF!ix launched it,; subscription rental service for a fixed monthly fw of $15.95. Under this pian, subscribcrs
could rent up to four DVDs per month. In Fcbruary 2000, Net ... 'ix modilied its subscription renlal scrvice to l'ruvide unlimted
rentals for a fixed monthly lee {lf $llJ.lJ5. At that time, t"xistng subscribers Wl're migmtcd to the unlimitl,<l renlal service al
Ihcr originaI fel' (lI $15.95.
NeIFlix.com.Inc.
NetFlix nllowed n subscriber to hnve up to four DVDs in his or her possession at one time. Once n
subscriber had viewed a movie and returned the DVD to NetFlix, the nl'xt DVD in the queue was
automatically sent to the subscriber. In this way, n subscribcr COLI Id always hnve movies in his or her
possession for viewing.
In order to fulfll subscriber requests -- an nveragl' ot 4.3 per month -- Ndflix maintancd nn
exlt'nsivp DVD lbrary:1 As of Dcccmber 11)99, the Netflix DVD library contnined approximatl'ly 5800
titk's and ()vpr 620,000 individuai discs. For each I1l'W subscribl'r, NL'lflix would nitially have to
pu!"chase appmximiltcly 5.6 new DVDs from wholl'salc distributors to satsfy custoll1cr requests nl ,ll1
average cost of $17.55 per DVD. AbOlii 20% of these DVDs would be l1ew rl'lmse titles, thosl'
l'l'k'<lSl'd by the studios in t1ll' last two months. In each 111011th, hnlf of these new rl'll'aSl'S would
bccollll' obsolete and en('r tlll' b,lCk catalogul. Thus, Ndflix would havc to buy an ,Wl'l'age 0.56 IWW
rde.lses l'ach month to sntisfy subscriber for nl'W releases. Howl'ver, if a subscrl1L'r
IL'rminated hs or her subscriptioll, thl' DVDs would rl'duce the nel'd to stock the DVD library l'or
Ill'W
As of thc end of 1999, thc nct book valuc of thc DVD library was about $K7 million. Exhibit 5
providl's informaton on thc accounting treatmcnt of the DVD libmry. For financiill reporting
purpOSL'S, Nl'tFlix deprcciated its DVD libmry aver threc years. However, becilllse of their digitaI
tcchnology, McCarthy expected thc aetual DVD Iibrary lo last an indefinite length of timI.' without
any dcterioration in qunlity cxcept for dnmage resulting from shipping or misuse. For this rcason,
NctFlix did not scI.! its older DVDs. Instead, discs natumlly migratcd into the back cataloguc as they
ngl'd.
T!tc Personal Mov.' Fil1der Service
In nddition to providing il "storcfront" for rcnting movics, NetFlix offered individun\jz,l'd movil'
recommendations as part of its Persollal Movic Finder Service. NctFlix asked ts subscl'bl'rs to
evaluate the movics they rented using il simple point-and-dick scoring systcm. Using this
information, NetFlix constructcd a preference profile for each subscribcr. Ihese profilcs Wl'rl' used to
slIpplya predicted mting for l'very movie on the Nctflix web site thnt was uniqlle to ench NetFlix
subscriber. As more subscribers were added to the databnse Zlnd ZlS existng subscribcrs rated more
movies, NetFlix expccted the qllZllity of its movie rl'commcndations to improve.
By providing reliable recommcndations for sclecting movies, Nl'tFlix sought to dl'Vl'lop sufficient
brand loyalty to compete effectively against potential future entrants as wclI as exsting video rentnl
retailers. In addtion, NetFlix anticipZltcd that the information collected from its subscribcrs would
also be useful to movie studios far promoting movies showing in theaters. According to thl' Motion
Picture Association of Amcricil, the industry spent Zln averagc of $21.4 million per ll10vie to market
nnd promote the theatrical release of new fcature films. Management belicved that their rapidly
growing subscriber base and Movie finder database could provi dc the industry with nn cffective
means to mnrket movics to a targetcd audience on a personalized basis. Finally, as Internet
technology developed, Netflix was hopcful that Hs technology could be uscd as a progmmmng
guide to Internet dclivered video. Through the development of its Personal Movie finder service and
the growth of its subscribcr base, NetFlx hoped to become the definitive online intermedinry for
choosing movies and other video entertainment.
4 In th(' first subscription month, NL'tflix would ship 10m DVDs lo $Inrt and .1n additional 4.3 DVDs un a"l'rage during thL'
remainder (lf thl' monlh.
5 Thc numbcrs in this pnr1lgraph nre bnsed 011 cnscwriter estimiltL'S.
4
NeIFlix.com,lnc.
COllsolidatiol1 ami lllllOvatiol1 in tlte HOllie Video Markef
Analysts cstim,lted that U.S. consllmers spellt about $25.6 billio!l on Illovie theater tickets and
home videos, with home vidco rentals accounting for about 32':1., or $8.3 billion.
6
Althollgh success at
the box officl' was important to Illovie studios, profitability often depended on revcnues from
illternative markets, such as home video, pily-pcr-view, and tclevision. In 1999, reVl'nues from thc
home video ll1arkd were estimateci to account for almost 50'X. of don1l'stic movl' studio rl'vl'nues?
Tlw home vidco industry was highly fragJ11ented. Ilowever, with a 14% decreilse in the nUl11ber
01' video stores opl'rilting in thc United Statl's since 1997, the industry was cOllsolidatillg mpidlyH In
1999, Blockbuster, Inc. was the wDrld's largest video rl'tailer with a 30'X, rl'venue share of the homl'
video rental market.'I Having ilhnost thrl'l' times as ll1ilny dOllll'stic stOl'l'S as its nl'<lI'est COI11Fll'titor,
Blockbustl'r estmilted that roughly 60% of the U.s. populiltion liwd within thrl'c miles o cl
Blockbuster Storl'. 'l'hl' typical Blockbusll'r store carried 4,500 different ll10vie titll's, 500 of which
were nl'W rl'lease tiUl'S. In 1999, approximate!y 78'X, of Blockbuster domestic !"l'n!al revenUl' was from
Ill'W releilSl' movies. l3lockbustcr also had beglln to rent movics in DVD fmm,lL In l99l), most
Blockbuster stores stocked betwcell 200 and 300 different DVD titles. Hl
Traditionally, movies were made available for distribution in the homc video m,lrkct ,1bout two
months after the end of thcir theatricul release. Video reotal retailers typicully purchascd copies of
vidcos from distributors and thcn rentcd them to thcir customcrs, kccping the rl'venlle genl'rated
from the rental and/or sale of the tapes. However, two major innovations were anticipilted to have a
permanent impact on the way in which the industry distributed movil's. They were: (1) revenuc
shnring and (2) video-on-demilnd.
Revenue sharing With the consolidation of the home video markct und the increasl'd
importance of the home video to movie studios, re\'Cnue sharing agreements bctween movic studios
and major retailers were becoming more common. Under a revenue sharing ilgreement, il rctailer
pilid a lower price for eilch videocassette in exchunge for sharing a portion of thc rental revcnue with
thc movie studio.
ll
Bccause rl'vcnuc sharing reducC'd. a retailer's required inventory nvestment,
retailers were willing to stock more copi es of each new rclease title ilnd customers were more likcly to
find a copy of thc movie they wanted to renI. Sncc implementing revenue sharing in 1997, the
typical Blockbuster store carried 60% more movie titles nnd stocked nearly four times the Ilumber of
vidcocasscttes.
Video-on-demand With thc widesprcad adoption of thc internet, Llllalysts bclievl-d that home
video would cventually be dclivered directly to consumers over high-spt.'Cd internet connections.
The eventual advent of video-on-demand meant that video retailcrs had a limited ti me frame in
which to position tnemsctves for this new environment. Atthough il wus generally agret.-d that such il
change would takc piace, therc WilS Icss agrccmcnt on thc lellgth of time it would take for the
6 Paul Kilgan Associates, Inc., ilS cited in NetFlix s..1 filing.
7 Paul J<agan Associates, Ine, as dted in Blockbuster 199<) Annual R"port
8 IJlockbustcr 1999 AnnuaI ({eport.
') Cnscwritcr
IO Blockbuster 19')<) Annual ({eport.
11 In li typical rcvenuesharing agrcement, il retailer mighl purchas,' il m'w rdease videocassette for I .'ss than $111 in exchnnge
for returning 40% l)f the rentnl reventle genernted during Ihe first six months tn the movie studio.
NeIFlix.com,lnc.
Jll'Cl'SSilry infrilstructurl' to be put in plnce or on wllo wOllld L'vel1tll<llly become tlle conLlIit for
providing hOllle video entertaimnl'nt.
Cl11/cl 11 Shm
Knowing tllnt NctFlix Ilad a limitl'd timl' frilille in which to nsselllbie il "criticni massI' of
subscribers, McCilrthy considered the l'ffect thilt entL'ring into revenlle-shilring ilgreements with
movie stlldios might hilvl' on projectl'd Nl'tFlix cash flows. Hl' iliso wondl'rl'd whether tlw major
l11oVl' studios that had already signed ngrcelTIents with B10ckbllster would be willing to sign similar
agrcel1)ents with il relativdy nL'W Internet startup slIch as NctFlix. Considering the enormOllS growth
rl'qllirel11l'nts facing NetFlix, McC<1rthy was concerned that revelllle-sharing agreenwnts alone might
ilO! free IIp el10ugh working capitaI to allow for il sllccessful o(fering latcr in the ye,1L McCarthyalso
considered whether NetFlix could afford to continue offering a free month of servicc in order to
attract potential new suhscrilwrs. At the same time, Iw wondl'red wl1l'thcr the company c(lulll i1fford
not to do so.
6
NeIFlix.o:-om,lno:-.
Exhibit 1 Income Statements fnr NetFlix.com, Ine. (thollsnnds of dollars)
Year Ended December 13,
I(NH
Revenues
Cost 01 revenue
Gross proli!
Operaling expenses:
Produci development
Sales and marketing
Generai and adminislrative
Stockbased compensation
T otal operaling expenses
Operaling loss
Other incarne (expense)
Inleresl and other income, nel
Interesl expense, nel
Net loss
SOllr{'l': C()l11pany reports.
1,339
1 311
28
3,857
4,815
1,358
1.151
11.181
(11 153)
114
(42)
(11,081)
5,006
4,;,F;;l
633
7,413
16,424
2,085
4 , 7 ~ ~
;;lQ,4
(3Q 031)
924
(29,845)
Nell'lix.com,lnc.
Exhibit 2 Balancl' Shl'ds tor NctFlix.com, Inc. (thollsands of dollars)
As of December 31,
Assets
Currenl assels
Cash and cash equivalenls
Short-Ierm inveslmenls
Prepads and olher currenl assets
T alai current assets
Rentallibrary, net
Property and equipment, nel
Deposits and other assets
T otal assets
Liabilities and Shareholders' Equity
Currentliabilities
Notes payable
Current portion 01 capitai lease obligations
Accounls payable
Accrued liabilities
Deferred revenue
Total current li abiliti es
Capitallease obligations
Note payable
T olal liabilties
Mandatorily redeemable conv. pref stock
Shareholders equity (deficit):
Convertible preferred stock
Common stock
Additional paid-in capitai
Deferred stock-based compensation
Accumulated deficit
Total shareholders' equity (deficit)
Totalliabilities and shareholders' equity (deficit)
SlIurcc: Company rcports.
1,061
635
1,696
2,011
1,062
8Q
1,000
579
3,063
1,640
118
6,400
172
6,572
6,321
4
3
8,100
(4,711)
(11.440)
(8.044)
4,849
14,198
6,322
72Q
21,240
8,695
4,499
:2:29

625
571
5,334
3,211
471
10,212
811
;2.959
14,982
51,819
4
7
16,087
(6,841 )
(41,2Q)
(32.028)

8
Nell'lix.com, Inc.
Exhibit 3 Quarterly Operating Resu!ts for Nt'lFlix.com, Ine. (thollsands of dollars)
1,170 2,135
1,276 1,764
9,004 10.844
(9.110) (10,473)
351 387
(149)
(8,908) (10.381)
Quarter Ended
JlIIll' 3D Sept. 30 March 31
1'1'1'1
847
663
184
1.324
1,954
532
787
4,597
(4,413)
74
(165)
(4.504)
S o u r n ~ : Company rcports.
Revenues
Cosi 01 revenue
Gross profit
Operating expenses
Produci developrnenl
Sales and rnarkeling
Generai and adrninislratve
Slock-based cornpensation
Total operaling expenses
Operating loss
Inlerest and olher incorne, nel
Interesl expense. nel
Net Ioss
854
670
184
1,533
2,930
553
1.203
6,219
(6.035)
112
(129)
(6,052)
(106)
2,106
4.994
404
1,50Q
371
2.450
6.546
596
1,252
NetFli".com, Ine.
Exhibit 4 Historicill ilnd Projected Unit Sull's, Avcfilgc Unit Pricc, and HOllschold Pcnetration Rilk-s
for Videocassette Recorders ilnd Digito! Video Disc Ploycrs during thc First Five Ycars After
Introduction
1
!\lIIlllal Sak"S
Milllou" or,
D V"kocassdl<"
Ikconkrs (veR)
IO
D D.g'lal VH.kO Di,r:
1'la\CI' ( D V J)
.lil

Iii
2 J
Ycnrs SJIle'\! intrmluclion
()
4
Il,,,,,choIJ l'cIlclmlioll Rat.:s and /lVcragc t Inir l'ricc
Pcn:cnf or
Doli""
IloIIsch"l,
i6
u
$'!IJO i)
$!!OO
$7!)()
$6f)()
$50()
$400
'I=::J VCR l'cllelmrioll __J
$)00 :c::JOVD l'enetralion:
I
I VCR Unir l'Ticc
$2()()
i
.--DVD UniI l'rice
'j;IO(J
'j;()
o 2 3 4 .5
Ycars sincc intruduc,j()I1
Sourc(': ConSlItners Elcctrnnics Manufl1cturcr's Association.
a Uni! sal<'S .. re sales to Je"ler". Consul11er sales ilre estimateli to be .. bm.1 f>ll% of Je,11er sales. for DVD pl.1yers, ycars 3, 4,
,md 5 are forcCl1Sled vallics.
10
Nc:-IFlix.('om.lne.
Exhibit 5 Rcntnl Library (thousands of dollafs)
Rental library 2.186 10.882
Less accumulaled depreciation (175\ (2.187)
Renlal library. nel 2.011 8,695
SI Hlrcl': l "oI'Hp.1ny rt'porb.