How not to get “Netflixed”

October 11, 2011, 7:23 PM UTC

The nuclear industry measures how long a radioactive material will retain its potency by its half-life — the time it takes for the material to lose half of its radioactivity. The half-life of Uranium-235 is 700 million years, for example. During the industrial era the half-life of a business model was typically measured in generations. Once the basic rules for how a company creates, delivers, and captures value were established, they became etched in stone, fortified by functional silos and sustained by reinforcing company cultures.

Those days are over. The industrial era is not coming back. The half-life of a business model is declining. Today’s leaders are either going to learn how to change their business models while pedaling the bicycle of the current one or they are going to be “netflixed.”

If netflix isn’t a verb it should be.

1. to cause disruption or turmoil to an existing business model
2. to destroy a previously successful business model
3. to displace the way value is currently created, delivered, and captured

Blockbuster started out with a compelling business model. Its value proposition was clear, enabling consumers to watch hit movies in the comfort of their homes. Blockbuster established an extensive value delivery network with stores conveniently located on every corner. Its first store opened in 1985 and it quickly grew to have over 5,000 retail outlets and 60,000 employees. It also had a smart financing model to capture value. It rented hit movies at a price consumers found attractive relative to the price of going out to the movies. Instead of paying a large upfront fee to buy videos from the studio (up to $65 per video) Blockbusters entered into a revenue sharing model with the movie studios including little to no upfront costs per video which gave them a huge advantage fueling explosive growth. Blockbuster started out on a roll. At its peak in 2002 Blockbuster’s market cap rose to $5 billion. In 2010 in filed for bankruptcy. So what happened? Blockbuster was netflixed.

It wasn’t as if Blockbuster didn’t see Netflix (NFLX) coming. They were just so committed to their bricks and mortar business model they couldn’t see or act beyond it. They were stuck in their current business model. Blockbuster didn’t see the emergence of DVD technology as a threat to their business model. They didn’t see it as a disruptive technology. They saw DVDs as a sustaining technology to improve the performance of their current brick and mortar business model. That all changed in 1997 when Reed Hastings got pissed off because he was charged a late fee by Blockbuster after failing to return the movie, Apollo 13, by the due date. Turns out, Reed Hastings was not alone in hating paying late fees. Blockbuster was so focused on expanding its current business model it had no clue it was about to be netflixed.

Netflix didn’t invent any new technology. DVD optical disc storage technology had already been invented. What Netflix invented was a new business model.

In 1999, Netflix moved away from Blockbuster’s pay-per-rental model and introduced a subscription model where customers paid a flat-fee for unlimited rentals without due dates, late fees or shipping and handling fees. Netflix’s business model story was to enable consumers to watch as many movies as they want in the comfort of their home for a fixed monthly price. The new business model caught fire with annual sales going from $1 million to $5 million in its first year. Within five years Netflix was a $500 million business and within eight years it had reached $1 billion in sales. In 2002, Netflix had one million subscribers growing to over 5 million in 2006 and over fourteen million in 2010. Hardly a niche business!

Blockbuster made the mistake most companies make in underestimating the disruptive threat of new technologies and innovative business models until it is too late. Blockbuster remained stuck in their bricks and mortar business model, naively treating Netflix as a niche player that they could ignore. They underestimated Netflix at their own peril. They attempted to react but too late. The constraints and pressures of their existing business model proved too great to overcome. Blockbuster was netflixed.

The Blockbuster story is about a business model that was successful until a disruptive technology and a new business model displaced it. The story isn’t unique to Blockbuster. All business models are vulnerable to being netflixed. Even Netflix has to worry about being netflixed.

Of course, the biggest threat of disruption to Netflix’s business model comes from the ability to download or watch movies directly online. It is only a matter of time until both videocassettes and DVDs seem like an antiquated way to access digital video content. Netflix has been aggressively evolving its business model experimenting with new online movie offerings and pricing models. But can Netflix avoid being netflixed itself?

Netflix initially tried to bundle streaming as a new product offering within its current business model. For customers that wanted to access movies through both the mail and online streaming it offered a popular pricing plan of unlimited streaming and one movie out by mail at a time for $9.99 a month. Many liked the offer but with increasing costs it wasn’t a sustainable proposition for Netflix. The growing cost of streaming rights and the increasing costs for bandwidth, infrastructure and support to make streaming available were making a one low price per month for unlimited streaming and DVD delivery untenable for Netflix. Without the cash to gain streaming rights for popular content Netflix would not be able to please customers interested in streaming. And of course customers who were only interested in a low price mail delivery model had no interest in paying higher prices for real time movie streaming. Something had to give.

Netflix announced a whopper of a price increase to all of its customers in July of 2011. They decided to get rid of the $9.99 bundled price plan and to separate the two offerings each priced individually at $7.99. It was a 60% price increase and customer reaction was immediate and angry. Blog posts and comments piled up across the Web in reaction and over a million customers voted with their feet by unsubscribing to the Netflix service. The business model that had worked so well for the DVD-by-mail service did not work well to deliver online streaming bundled with the mail service.

It only took two months for Netflix’s next move. In September of 2011 it decided to split up into two discreet business units. One for online streaming continuing to operate under the name Netflix and another independent business unit established under the new name Qwikster to operate the company’s legacy DVD-by-mail service. It became clear to Netflix that trying to grow the streaming business within the core DVD-by-mail business model wouldn’t work.

The most important lesson for all leaders to take away from Reed Hastings’ experience at Netflix is from his simple but profound admission, “In hindsight, I slid into arrogance based upon past success”. Hastings goes on to say in a blog post, “My greatest fear at Netflix has been that we wouldn’t make the leap from success in DVDs to success in streaming. Most companies that are great at something — like AOL (AOL) dialup or Borders bookstores – do not become great at new things people want (streaming for us) because they are afraid to hurt their initial business. Eventually these companies realize their error of not focusing enough on the new thing, and then the company fights desperately and hopelessly to recover. Companies rarely die from moving too fast, and they frequently die from moving too slowly”.

And then less than a month later after losing over 1 million customers and the bleeding continuing Reed Hastings announced Netflix had changed its mind again and would not be going forward with a separate Qwikster business model and unit. They would continue to blend the online and DVD-by-mail offerings and pricing. He amazingly contradicted his comment that companies rarely die from moving too fast in his announcement saying, “There is a difference between moving quickly and moving too fast.” It was painful to hear and to watch Netflix in the throws of being netflixed.

I don’t know how the movie will turn out but one thing is clear. Business models just don’t last as long as they used to. They are all vulnerable to being netflixed. No one and no organization are immune, not even Netflix.

Saul Kaplan @skap5 is the Founder and Chief Catalyst of the Business Innovation Factory.