TiVo Inc. has what every young company dreams of: smart executives, a killer product, famous (and fanatical) customers, a huge potential market. But is it a business? Will it ever be? And if a company as savvy as TiVo can't break through, who can? A case study in the promise -- and perils -- of innovation.

Inside the Silicon Valley headquarters of TiVo Inc., there's a fantasy living room where meetings with visitors often begin. The furniture is pristine and the oval coffee table is free of magazines and bags of chips. The only objects on its surface are a telephone and TiVo's distinctive peanut-shaped remote control. The sofa and chairs all face an entertainment center containing a big-screen television that is linked to several TiVo boxes (a few are available; a few are works in progress).

This living room, the company's executives hope, will be a prototype for 100 million living rooms across North America. The VCR will be replaced by TiVo's $399 flagship device, the personal video recorder, or PVR, which allows couch potatoes to more easily record their favorite shows, pause live TV, get suggestions about programs that they might enjoy, and fast-forward through ads. "We don't view our market as being just the early adopters or the $150,000-plus households," says Morgan Guenther, TiVo's president. "If we can make the product easy to use and get the price down to somewhere around $199, this is a mass-market opportunity."

Alas, the real world is messier than TiVo's perfect living room. The company is experiencing firsthand the brutal realities of introducing a disruptive technology into a marketplace filled with obstacles. Customers are usually slower to embrace new products than forecasters predict. Investors, initially flush with excitement, become skeptical and demand immediate results. (TiVo, which has accumulated losses of more than $400 million since it was founded in 1997, has watched its share price fall from a peak of nearly $79 to a valley as low as $3.) Me-too competitors vie for customers who are prepared to buy. (The company is locked in a nasty patent dispute with another entrant in the PVR market, SonicBlue, which makes ReplayTV. That device allows users to trade shows over the Internet.)

And yet ... TiVo has genuine strengths. The company's executive team, led by CEO Mike Ramsay, has been quick to change course in response to changes in the market and on Wall Street. Its engineers have been upgrading the product and refining its performance since its debut in March 1999. The TiVo Series2 launched in February, and the company continues to innovate on virtually every facet of the viewing experience -- even on elements as mundane as the remote control.

Most important, TiVo has struck a chord with customers. The company has amassed a base of devoted users who practically foam at the mouth when they talk about how TiVo has changed their TV-viewing experience. The company's name has become a verb: The phrase "Did you TiVo that show?" is rapidly gaining on "Did you tape that show?" in the pop-culture vernacular. TiVo has garnered favorable mentions on such hit programs as Friends, Sex and the City, and Live With Regis and Kelly. Indeed, the product is so promising that TiVo has become a four-letter word on Madison Avenue, a symbol of dire threats to the television networks and the advertising business.

Right now, TiVo's base of paying customers is about 422,000. Ramsay is on a mission to push that number to 1 million. "At 1 million users, our business model will generate significant free cash flow," he says. "At that point, we'll be able to sustain ourselves and reinvest in future growth. We do think of 1 million as a bit of a magic number."

In short, the TiVo story is about more than TiVo. It is a case study in the promise -- and perils -- of innovation in an unforgiving market. TiVo has a killer product. But can it become a great company? Will it become a big name in the future of technology and pop culture? Or will it go down in business history as yet another casualty of first-mover disadvantage? Will it be to PVRs what Sony Betamax was to VCRs, what the Altair was to personal computers, what Atari was to video games?

"There are lots of cautionary tales," concedes Guenther, "where the inflection point came, the technology went mainstream, and the company that was there first couldn't take advantage of it. We know that we have to focus on execution if we want to stay on top of the market that we created. What does it take to get the mass market to adopt this technology?"

Here is TiVo's four-point program to answer that question.

A quick primer on TiVo: It's essentially a giant hard drive in a box that hooks up to your TV, a cable or satellite feed, and a phone line. Using the phone line, TiVo dials in to a server to collect information about what shows are on when. Then, from the couch, you use the TiVo remote control to navigate the schedule, selecting shows that you'd like to record. You can even tell TiVo to record every new episode of The Sopranos that airs over the course of a season. Unlike a VCR, certain versions of TiVo can record two shows that happen to air simultaneously.

You can also use TiVo to put a show "on pause" while you answer the door -- and return to it without missing a thing. And if you let TiVo store the first 15 minutes of a show before you start watching it, you can skip through the commercials. On its lower-quality setting, the Series2 can record up to 60 hours of programming. There are countless auxiliary functions as well. TiVo can track what types of shows you watch frequently and suggest others that you might enjoy.

But here's the rub: There's a big difference between what TiVo can do and what even the most accomplished couch potato has the energy to learn how to do. Most people aren't really itching to change their viewing habits -- even if there's no doubt that new habits would vastly improve their experience. "There's tremendous inertia associated with watching TV," explains Brodie Keast, a TiVo senior vice president who spent 10 years in product marketing at Apple. "There's no other human behavior that's as entrenched. We've been watching TV the same way our whole lives."

Convincing consumers that there is, in fact, a better way to watch TV is a big part of Keast's job. "When I first started here, people would say, 'Oh, TiVo. They make those great sandals,' " he recalls. Since then, he has been trying to hone how TiVo tells its story and explains what its product can do -- all without the multimillion-dollar marketing budget that was slashed in deference to Wall Street's demands for financial performance. "We're trying to build a new category and brand and change human behavior on a mass scale. We're also trying to do those things on a shoestring budget," Keast explains.

Initially, the company tried to avoid comparing its product to a VCR. "People don't like their VCRs, because they don't know how to use them," Keast says. "They don't understand why they should want another VCR, even if it is a glorified VCR."

TiVo's original position was that the device was like having your own TV network where you get to decide what's on and when. "But there was no context," says Keast, recalling the shortcomings of that message. "People said, 'What the hell are you talking about? Personal TV network? Huh?' "

Keast caved in on the VCR comparison. Now the positioning statement says that TiVo is like a VCR, except that it digitally records your favorite shows on a hard drive, letting you watch them whenever you want. "There were questions about using the word 'digital,' " Keast says. "We worried that people might envision their TVs crashing. But our market research found that people were comfortable with it. They figure that if it's digital, it's good."

TiVo doesn't have the money to shout its carefully crafted message from the rooftops, so the company has decided to focus instead on strategic whispering campaigns. Keast has worked to put TiVo sets into the hands of Hollywood celebs and sports stars such as Jay Leno, Joe Montana, and Rosie O'Donnell. "These are people who are influential with consumers and who have a big impact on pop culture," Keast says. "It's incredibly valuable to have them talking about TiVo in a positive way." In exchange, the company sometimes asks celebs for photos or endorsements, some of which appear on its Web site.

TiVo also tries to foster word of mouth among its less-renowned users. The company encourages TiVo owners to host what might be dubbed "TiVo-ware parties," bringing together friends for an event like the Grammys, the start of the NFL season, or the season opener of a hot show. TiVo-ware parties give nonusers the chance to experience some of TiVo's features, such as pausing the show or rewinding it for an instant replay. TiVo sometimes creates special content around a big event, such as the Super Bowl or the Oscars, that only TiVo owners can watch.

"We want our prospects to get to experience the product in a comfortable environment from people they trust," Keast says. TiVo-ware parties are more low-key than their Tupperware-oriented predecessors, however. "The TiVo owner doesn't have a sales quota," Keast says. "The evening doesn't end with, 'Can I take your order, please?' "

Keast says that seeing TiVo in action at a friend's house is one of the company's best sales strategies -- but it's one that the company has a hard time controlling. Occasionally, TiVo-ware parties can go awry, as happened earlier this year during the Oscars. TiVo's program guide listed the awards ceremony as running for three hours, and when the show ran long -- nearly an hour and a half long -- many people using TiVo to record the show and watch it later (after serving dinner, for example) found that they had missed some of the most important awards.

It was a frustrating experience for TiVo users, who may not have known that the device has the ability to "pad" up to three extra hours onto a show that might run long. It was also a learning experience for TiVo's executives. "In the future, we'll remind our subscribers that for big live events, they should probably pad them at least a little bit," Keast says.

TiVo executives have rethought how they sell their product's virtues to potential customers. They have also rethought where they sell the product. Initially, TiVo recorders were available at many stores that carried consumer electronics, including "big box" retailers, such as Target and Wal-Mart. "We probably had TiVo overdistributed," Keast says. "Nobody was moving a huge volume on a per-store basis, so they weren't excited about building our business." TiVo was everywhere, but it was getting nowhere.

Earlier this year, the company abandoned ubiquity as an objective and decided to concentrate on one retailer: "Best Buy gets more velocity," says Keast. "And we both have incentives to make things work." TiVo promotes Best Buy on its Web site and on the service, and Best Buy promotes TiVo in its stores. Best Buy salespeople get special training in how to use TiVo. They also get discounts on purchasing a TiVo set. "You can train them until you're blue in the face, but when they use the product, they really understand it," Keast says.

Not every distribution wrinkle has been ironed out, however. Some Best Buys have a legion of well-trained salespeople, but no TiVo recorders in stock. Balancing demand with supply has been a constant challenge. "We had a supply shortage earlier in the year," CEO Ramsay explains. "We are working through that. Then, when we started the Best Buy relationship, the demand was higher than anticipated. They didn't order enough product because, frankly, neither of us knew that there would be so much pent-up demand."

It will be crucial for TiVo to solve such issues if the company hopes to become a staple of the home-entertainment center. It will also require more-inventive marketing. "We're trying to be quick and nimble," Keast says. "Nobody can come up with a quantitative assessment of what it's going to take to grow this market. It's too complex. We need to try lots of things faster than our competitors."

Sitting in the company's fantasy living room, Jim Barton, TiVo's cofounder and chief technology officer, recalls the first time he got a computer to store a live TV signal and play it back, in 1998. "That's when we knew it would be cool. We spent 13 incredibly frantic months developing it," Barton says.

Now, when he goes out to restaurants, he's often buttonholed by waiters who have TiVo sets at home and want to suggest new features. "A lot of the time, they want a feature that's already built into the TiVo," he says. That's why simplification is such an important crusade for TiVo these days. That doesn't necessarily mean paring back features. It means making TiVo easier to set up, reducing the number of parts that go into the device, and making the internal architecture less complex.

Barton realizes that he's not a typical TiVo user. His own device has been hacked using open-source tools that let him add a huge 120 gigabyte drive to the 40 gigabyte drive that came standard. For the less technically inclined, one key goal has been to reduce the number of steps required to get a new TiVo hooked up to the user's TV and phone line, at which point the device dials up to a main server to configure itself and download the latest program guide. Ramsay says that the setup time is down to about five minutes, followed by an hour of configuration that the TiVo does by itself through the phone line.

Barton's team is still at work, though, to streamline the internal design of a TiVo box and to reduce the number of components that go into it. "Our ongoing challenge is, How do we get the cost of the hardware down?" he says. "We're always trying to use fewer chips and get the size of the power supply down. Our big goal is to have a disk drive with a single chip, and we're headed in that direction." (Today's TiVos contain three main chips.)

The simplification crusade, combined with the decreasing cost of disk drives, will help TiVo hit what it thinks is a magic price point: $199. "You really need to get to an average selling price of $199 to drive the category," Guenther says. "That's probably the point where volume would really take off."

But there's a chicken-and-egg problem standing in the way of $199 TiVo sets. In order to gain the economies of scale in manufacturing that are necessary to reach a $199 price point, TiVo needs high sales volume. To get that high sales volume, it needs a lower price point. In the days of cheap money from Wall Street, the strategy was obvious: Use investor capital to subsidize hardware sales. That is no longer an option. Hence, the fourth element in TiVo's new strategic program.

Mike Ramsay is just back from a trip to Japan, where he conducted meetings and seminars with consumer-electronics makers in an attempt to convince them to embed TiVo's software in their products. "There was a huge level of interest," he says. The visit was an important one, since Ramsay knows that TiVo's success does not hinge on TiVo selling a lot of its own boxes but on cultivating a community of consumer-electronics makers and cable and satellite providers who want "TiVo inside" their boxes too.

Sony, for example, recently licensed TiVo's software for use in a PVR that it is marketing in Japan. And AT&T Broadband and DirecTV offer TiVo-enabled set-top boxes. Eventually, Ramsay envisions all kinds of devices with TiVo inside, such as a combination DVD burner and TiVo recorder that would enable users who want to archive shows for their own library to transfer them from TiVo's hard disk onto a DVD.

TiVo's task at hand is to preserve its lead and its premium brand as its competitors improve their offerings. "When companies come into a market second or third, they can see what works and what doesn't," says Forrester Research analyst Josh Bernoff. (Bernoff has two TiVo sets at home.) "Later entrants can go for volume, which means that they can do it cheaper. They can turn the business into a commodity business, which favors big, well-funded companies, not startups."

Ramsay is so focused on partnerships that he's rarely in his office. More often, he's on the road talking to companies that can build TiVo's software into their products and help build TiVo's subscriber base. But even 1 million devices embedded with TiVo's software, all generating $12.95 a month in subscription revenue for the company, won't mean that TiVo is home free.

Ramsay knows that many of the dynamics that he was able to control when TiVo was a first mover in the world of PVRs are now out of his hands. So he's pushing his team to control the things that they can control: marketing, the cost and simplicity of the product, and partnerships. "Those things are all really important to us if we want to stay on top of this trend as it takes off," he says. "And we do intend to stay on top."

Contributing editor Scott Kirsner (kirsner@att.net) writes from Boston's North End. Learn more about TiVo on the Web (www.tivo.com).

Sidebar: A Remote That Clicks

For such a revolutionary product, TiVo's appearance is pretty unremarkable. So the company's design team, led by Paul Newby, seized on the idea of developing a unique remote control that would set TiVo apart. "We knew early on that we needed something iconic, something that would embody TiVo's friendliness and ease of use and stand out among the coffee-table fray," says Newby, who earlier in his career designed bicycle helmets for Bell Sports and computer workstations for Silicon Graphics.

One of the signs that Newby and his team created a distinctive clicker: He recently got a photo in the mail from a TiVo user who had built a soapbox-derby car in the shape of the TiVo remote. Here are three of the principles that guided Newby through the design process.

1. Cut through complexity. Too many buttons make a remote unfriendly to users. "We wanted people to be able to figure out what every button does without referring to the instruction manual," Newby says. "We also wanted to make sure that the buttons were big enough so that people could feel them in the dark." Newby adds that "Braille-ability" -- being able to use the remote in the dark or without glancing down -- was an important objective.

2. Iterate, iterate, iterate. Newby says that he collaborated with industrial designers at Ideo to find a shape that would set the TiVo remote apart. They ended up with a peanut-shaped remote. They went through more than 40 foam mock-ups to get the shape just right. And the iteration didn't stop even after the product started shipping in 1999: The TiVo Series2 includes a remote that is slightly longer than the original, making it easier for users' fingers to reach the number keys on the bottom and rendering the remote cheaper to make.

3. The genius is in the details. No problem was too small. When beta testers reported that the keys on the remote were sticky, Newby and Ideo decided to add a silicone coating that made them feel smoother. They also opted for an unobtrusive, sliding battery door -- which is less likely to tempt users to fiddle with it until it breaks. "It's easy to have a lot of energy and momentum at the start of the design process," Newby says. "But success is about maintaining the vision even through the most grueling details."

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