The book that plunged Netflix into controversy

October 11, 2012, 6:50 PM UTC

By Kurt Wagner, reporter

FORTUNE — In writing her first book, it’s clear that former Reuters journalist Gina Keating didn’t just phone it in. After more than a decade covering media companies, Keating’s book
offers an in-depth look at the triumphs and tribulations faced by the online streaming service. Netflix, which began with a staff of eight in 1997, not only survived the dot-com bubble but went on to help put it’s biggest competitor, Blockbuster, out of business.

The book hits bookshelves Thursday amidst limited public scrutiny surrounding the accuracy of some of its central anecdotes, most notably a proposed $12 million acquisition offer from Amazon (AMZN) in 1998. Netflix (AMZN) has since denied the proposal ever occurred. Keating also reports that the company was not actually created after current CEO Reed Hastings was charged an extravagant late fee after renting the movie “Apollo 13” in the mid-90s.  Instead, the book sheds light on the early contributions of Netflix’s lesser-known Co-Founder, Marc Randolph.

In a phone conversation with Fortune, Netflix VP of Corporate Communications Jonathan Frieland offered the same statement released to the Associated Press earlier this week regarding Keating’s new book: “People interpret history in all kinds of different ways, and a lot of the anecdotes in the book don’t square with the way we remember them,” Friedland said. “The gist of the story, that Marc and Reed created Netflix together, is correct.”

Fortune caught up with Keating on the eve of her book’s release. What follows is a lightly edited transcript.

Fortune: The book discredits the story that Netflix began after current CEO Reed Hastings got a $40 late fee for a movie rental. How does a story like that take shape and what’s the real story behind Netflix’s start?
Gina Keating: We all know that story as journalists because that’s the story that they sell. I was told after interviewing the Netflix founding team that that [story] began as a construct to explain to people how Netflix worked because the model in 1997 was very foreign to consumers. Nobody really shopped online. The idea of renting a movie online and then having to send it back, nobody did that. So the idea was to tell that story so that people would understand you didn’t have to pay late fees and you could keep it as long as you wanted.

So that’s how that started and actually, the real story is that there were a couple of direct marketing people, Marc Randolph, Christina Kish and some others who were actually the founding group of Netflix. Reed Hastings gave money and he helped Randolph refine the idea for this online DVD rental and sales company — because that’s what it was at the beginning — but he wasn’t directly involved with it for about two years.

Netflix committed to DVDs at a time when most industry leaders, including the movie companies, were still sold on VHS. Can you put into perspective the kind of risk that Netflix was taking at that time?
Yes, it actually was pretty brave on many levels because DVD had really only been released into probably six test markets when they decided to go ahead and do it. They couldn’t even get a DVD to test mail it so they used a CD. And they had the good fortune to incorporate into their team Mitch Lowe (formerly the President of Redbox), who was the president of the Video Software Dealers Association, and he was working on the transition with the studios and really pushing for the DVD format to be the dominant format. But there were other formats, and one that was very popular was called DIVX. DIVX had a lot of money behind it, a lot of studio money, (and) there was an entertainment law firm that was backing it to the tune of about $100 million, so it was not a sure thing that DVD was going to be the digital format of choice. So that was a real leap of faith.

Netflix gave way to Amazon early on in the DVD sales market in exchange for an online partnership.  Do you believe Netflix gave up their place in the DVD sales market too quickly?
No, I don’t. I had a lot of discussions about this with Christina Kish who was the customer retention person, and she was really upset by that decision that Reed made. He kind of unilaterally came in and said, ‘Look, we need to be good at one thing. We can’t compete in this market because we are too little and we can’t get any break on inventory and we’re going to be crushed by not just Amazon but the big box companies. If we concentrate on DVD sales – which at the time was most of their revenue – we’re going to be pushed out of the market. So we need to get rid of this revenue stream and live with rental and really make rental what we do best.’ And that’s a message that Netflix has told itself over and over and it’s really the key to its success.  They do one thing, and they do one thing better than anybody. And I think that that was critical to their success. He was absolutely right. And it’s not like it didn’t cause heartburn for all the members of the founding team – they were terrified about it. But that’s what makes (Hastings) a great CEO.

You reported that Amazon offered to buy Netflix early on for $12 million, but Blockbuster also had an opportunity to buy Netflix for $50M in 2000 and passed. Obviously the decision was a costly one, but what was Blockbuster’s thinking at the time?
This is very funny. At the time there were two concepts that (Blockbuster) could not wrap their heads around. One of them was, ‘why would anyone want to do this?’ Why would anyone want to wait for a video to come in the mail when there was a Blockbuster store literally within five miles of 95 percent of America? The Blockbuster executives in Dallas, they all got free rentals at their Blockbuster store, and that was really an oversight because they thought, ‘why would anyone want to go online and do this?’

The other thing is they had a report by Kagan that the online-rental market would never grow beyond 3-4 million people. Blockbuster at the time had about 60 million unique users, probably about 20 million of them were active. And it just didn’t seem worth it. And that’s what they were thinking when Reed came in with Barry (McCarthy) and Marc to make this offer to them. They thought, ‘$50 million, that’s crazy! We can do this ourselves if we want to.’ Which is a mistake everyone who has competed with Netflix has made. Because it looks so easy. You just buy a bunch of DVDs, get some warehouses and just mail them around, but it just doesn’t work that way.

The book has a number of interesting and sometimes humorous anecdotes – notably the time Netflix accidentally sent customers disks containing hardcore Chinese porn instead of Bill Clinton’s Grand Jury Testimony in the Monica Lewinsky matter – what was your favorite anecdote from reporting on the book?
One of my favorite anecdotes was from 2004 when Barry McCarthy, the CFO, decided he couldn’t leave Netflix because of the challenge they were facing with Blockbuster and Amazon. [Netflix] was on conference call with investors and Blockbuster people had the conference call on speaker phones all throughout the office and when Barry mentioned he was going to stay because “you don’t leave your friends in a knife fight.” The people at Blockbuster immediately stopped what they were doing and mocked up a cartoon with Barry holding a knife and John Antioco, the CEO of Blockbuster, wielding a machine gun. And underneath it there was some sort of profane caption saying, “this idiot thinks he’s in a knife fight.” And I just thought, man this is perfect. And that sort of incident really permeated everything about the competition between Netflix and Blockbuster. It was kind of silly in a way but it just showed you how seriously they took this.

Where do you see Netflix sitting as a player in the entertainment industry five years from now?

I mean everything is a bit cloudy right now, but I would always bet on Reed Hastings after watching him for seven years. He just has a really tremendous vision for what people want because they have 15 years of data they have collected with their website which is basically a market research platform. What he thinks customers want, I think he has a very good vision for it. I think sometimes he doesn’t execute with as much patience as he should, but what he says I think we should pay attention to. And what he has said is that television is going towards a more internet informed model where you’re going to have a lot of À la cartechannels including Netflix, Hulu if it makes it and whatever little channels you get. You’ll basically have something that looks like an iPad where you’ll have channels that you pay for instead of cable. I don’t know how fast that will evolve but if he’s correct and that’s the way it goes, I just think they’re going to keep their place as one of the top subscription-rental models in the U.S.