Acquired - Short- The Death of Sega

0:00Okay, let's hear your best Sega screaming pressure. Sega! Is the emphasis more on this set? Sega! They talk about it in console wars. Yeah, the voice actor. And he was sick. I think he had thrown up earlier in the day and he was just in such a bad physical and mental state that he could do this insane scream. It was perfect. The cost you pay for great art. Who got the truth? Is it you? Is it you? Is it you? Who got the truth now?

0:31Welcome to this episode of Acquired, the podcast about great technology companies and the stories and playbooks behind them. I'm Ben Gilbert. I'm David Rosenthal. And we are your hosts. Today we have for you our first acquired short. There are some stories that deserve three or more hours to chronicle the entire company history start to finish, but there are also some stories or perhaps chapters of stories that can be told in an hour or so. Now, in Nintendo Part 2, I asked David a question, how exactly did Sega manage to go from having over half the video game console market in the US with the Sega Genesis?

1:19to abandoning the console business entirely after Dreamcast in a few short years. And David, you gave us a quick short answer, but we were both sort of looking at each other afterwards thinking there is so much more to this story. It really does deserve its own episode. And frankly, it's a nice opportunity for us here at Acquired to take a look at a company that didn't become hugely successful and what the lessons we can learn from that one are. So we bring you today.

1:48the death of Sega. This could be really fun. Experiment. We get to tell this story right. Listeners, let us know if you like this and we might do more of them. Yep. Let us know in the Slack acquired.fm slash slack. It is the best place to discuss episodes after we release them. Tons of folks joined after the Nintendo episodes. There's a lot of great video game discussion right now. Check out ACQ to our second show with interviews.

2:13The most recent interview was with David Xu, the founder and CEO of Retool. All right, listeners. Now is a great time to talk about a new partner of ours here on Acquired, LaGoura, the agentic operating system that is redefining how the world's best legal teams work.

2:32Yup, it's sort of obvious that AI is going to completely change the legal industry. I bet most of you listening have dropped a contract into some sort of AI chatbot out there. Lugora took that insight and asked the question, what if you really built something with that power from the ground up for the legal industry? So the founders did exactly what great founders do, operate with obsessive customer focus. They embedded inside a massive law firm.

2:58for months. They sat with the lawyers just watching how the work really gets done. And that's how you get features that customers love, like tabular review, where you drop in a folder of hundreds of contracts and it pulls every key term into a grid a lawyer can actually work with. Lugora's bed here is interesting. Since it lets each lawyer handle more complexity, any given person can increase the quality of their work and do higher value work. And this means that the pie can grow even as each individual task takes less time.

3:27And they recently launched LaGora agent offering greater intelligence and performance. The agent lets lawyers set an objective. Then it can handle the planning and the execution and delivery of the final product. Legal teams get to maintain full control and transparency since they're still involved where judgment is required. And LaGora works where you already work. You can use it within Microsoft Word while redlining or drafting. The early LaGora numbers essentially speak for themselves when they have a head-to-head pilot with their top competitor they win 70% of the time LaGora now has over a hundred thousand lawyers on the platform from 1200 legal teams in 50 countries and crazily they went from one million to a hundred million in ARR in about 18 months truly insane numbers and that is the real test

4:20Plenty of things demo well, but the question is whether a busy associate actually reaches for it during crunch time, or whether a partner trusts it before going into a conversation with a major client. If your legal team wants to check it out, whether you're a law firm or you're in house at a company, you can learn more at logora.com slash acquired and just tell them that Ben and David sent you.

4:41And with that, this show is not investment advice. Dave and I may have investments in the companies we discuss, and this show is for informational and entertainment purposes only. We could technically still invest in Sega today. Sega Sammy Holdings. Not quite sure we'd want to, but let's get into it. Spoilers! So, we start our story in round, call it 1992, 1993. Sega and its Genesis.

5:09as it was known in North America has battled Nintendo and the Super NES to basically a tie in the US home console market, which really in practice, if you go listen to our Nintendo series, was beating the pants off of Nintendo. Like, Sega had no right to get to 50%, maybe even 50% plus market share, given how far behind they came from. Imagine you're a startup and you're fighting some big incumbent and within three years, you get to a basically 50-50 market share.

5:38It's totally nuts. The Genesis, I mean, it was the cool console in the 90s. It had Sonic. They've got John Madden football. They've got great sports franchises. They've got the Mortal Kombat version with the blood. Oh, the real red blood, not the Nintendo tones down gray blood. And they have about a 30 million total unit install base of the Sega Genesis around the world. The vast majority of which about 20 million is in the United States.

6:06Yeah, and this is basically the best video game consoles we're doing at the time. Years later, the PlayStation 2 with 150 million, but no one was doing 100 million plus units sold game systems at this point in history. So 30 million, rock solid, huge player in the market. A great base to build on. Yes. Now, also at this time, and call it 1992, 1993, it has become clear that compact discs are the future.

6:36Not just for the video game industry, but for everything, CD album sales and CD players are on their meteoric rise at this point. It is a huge driver of business for companies like Sony. In the personal computer industry, neighboring to the gaming industry, CD ROM drives are now becoming standard in PCs. This is how software is shipping. This is how games are shipping in the PC industry.

7:01And the trade-off with games is, of course, a cartridge doesn't really require loading time. The CD, while it has a ton more storage, does have trade-offs where it needs to load stuff onto the machine. Yeah, and there's one other really big advantage of the CD medium for the business side of the industry, which is that CDs are much lower cost to produce than cartridges. Cartridges, you gotta like put silicon in there. They have chips. CDs are just...

7:31optical discs, you can stamp these out for a tenth, a hundredth of the cost of a cartridge. Penis. So it's obvious that the home video game console industry is also going to move to the CD medium as its primary distribution technology going forward. And the way right now that people in the industry are thinking that this great migration is going to happen is not via new consoles, but via add-on.

8:00peripherals to existing consoles. Looking back now, this was obviously a very, very poor path. An evolutionary branch of the gaming tree that mercifully died off. But at the time, everybody seemed to be doing it. There were other consoles like Atari's Jaguar console, came out with a CD-ROM add-on, the NAC PC Engine in Japan in the US. It was called the TurboGraphics console. That came out with a CD add-on. And Of course, famously, Nintendo is working on a major partnership that they've announced that everybody knows about, with none other than Sony to make a CD-ROM add-on for the Super Nintendo that would be known as the Play Space Station, the Sony Play Station add-on to the Super Nintendo.

8:52We'll come back to that in a little bit that doesn't go as planned. This is now our third episode in addition to Sony and Nintendo, where we've talked about this. So, of course, back to Sega, they are working on a CD-ROM add-on too for the Genesis. And just like with the Genesis, they had beaten Nintendo and the Super Nintendo to market with the first 16-bit console. They want to make sure that they beat Nintendo and Sony to market with the first CD-ROM add-on.

9:22So in late 1992, they launched the Sega CD add-on for the Genesis in North America. It comes out with this game called Night Trap, which is a full-motion video game that uses like, it's basically a playable movie. It's a really crappy game, but people think that this is the future that CD-ROM technology is going to enable. It's like a zombie slash, like a teen horror flick that you basically play as a video game.

9:50This is one of the games that gets Congress all spun up about. Video games are corrupting the youth that leads to the creation of the entertainment software ratings board, the video game industry version of movie ratings that comes out. Radity for everyone. Yeah. Exactly. So funny. Go back and look at this stuff today and you're like, yeah, compared to Call of Duty, you're like, this is nothing. Seriously. Grand theft auto. Yep. But ultimately, despite all this, Handering over these games and everything coming out with these CD add-ons. There is a fundamental problem with what Sega is doing here, and that is that add-on technology for consoles is never really a good idea, because the business model of the video game console industry, it's a razor-and-blades model, and the way that video game companies like Sega, like Nintendo, like Sony in a minute,

10:47make all of their profits is from the software sales, not from hardware sales. And so you want to have as big of an install base of consoles as possible to amortize the software sales across. So when you're selling an add-on console, you are limiting the target market to the 30 million people that already own a genesis. It will be smaller by definition than the market base that you've already created. And this creates a huge problem because then developers don't want to make their best games for a limited install base of consoles. Consumers don't want to go by a platform that's only going to have a very limited number of good games and it quickly becomes a death spiral. So the Sega CD sales, despite starting off relatively strong, stall out quickly. Sega only sells about 3 million Sega CD units versus the 30 million plus Genesis units that they've sold.

11:46This is a flop for them. Now Nintendo, by either luck or skill or maybe just being slow in Nintendo, they never actually come out with the CD add on for the Super Nintendo and the Sony partnership falls apart. So they kind of avoid this disaster that Sega stumbles into. But after the Sony partnership fell apart, didn't they form a new partnership with Philips to create the Nintendo CD thing?

12:13They did, but that delayed everything enough that everybody kind of realized that this was a bad idea and Nintendo basically also abandoned that project and let Phillips come out with their own console. I think it was called the CDI, nobody supported it, it sucked. It wasn't part of the Super Nintendo ecosystem. Okay, so what does Sega do after the Sega Genesis CD add on is abandoned? Well, you would think.

12:39Just like Nintendo sort of did here, you would learn your lesson. Console add-ons are a bad idea. You've got all these problems with it. It's a limited market. You cut your losses. You move on. You just embrace the next generation. That's the logical thing to do here, right? Yep. That is not what Sega does. They decide that they are going to follow up their failed console add-on with another failed console add-on. That's right.

13:07the infamous and infamously terrible 32X, which launches in the fall of 1994. This is another hardware add-on for the Sega Genesis system. The plug-in to the top of the console and it adds a 32-bit processor to the Genesis. And it works sort of like the same way a game genie worked, right? You like put it in where your game cartridges go and then That way when you put your actual game cartridge on top it's sort of like stacked like a tower. Yes, exactly. This whole thing is so hair brand. I think it added more colors maybe to existing Genesis games but then it also had its own 32x games that you bought separately for it. This thing was just an unmitigated disaster. One of the worst video game industry decisions of all time. Huh, okay. Yeah, so the 32x.

14:03sells less than 1 million units total. And in the meantime, almost immediately thereafter, Sega also rushes out a separate brand new native 32-bit system to market called the Saturn. What a nightmare. This makes no sense what's going on here. The story goes that all of this was basically a decision handed down from Sega in Japan. They order Tom Kalinsky, the CEO of Sega of America, to launch the Saturn. Sega of America doesn't really want to do this, but they don't have a choice. So they spin up their patented brilliant Sega marketing launch playbook for the Saturn. They announce to America that September 2nd, 1995 is going to be Saturn Day. It is Saturday, September 2nd. And the Sega Saturn is going to launch on that day. But then at E3 in May of 1995,

15:01They shock the world Tom Kalinsky comes out on stage for the Sega keynote and says Actually, I know we told all of you that we were gonna launch in September Well, surprise we're launching today the Sega Saturn is coming out right now The press the industry the developers here. They're all like what? It's like exciting, but confusing this makes no sense There's no Sonic game ready. There's no third-party games At all, the retailers aren't prepped. They don't know to expect this. There's been no marketing. None of the groundwork has been laid. In fact, everybody thinks this thing is coming out in September. It's really weird because it's like everyone's sort of recent hero, the David versus the Goliath of Nintendo, seems like they should be firing on all cylinders. But you have the market confusion with a 32X and the Sega Saturn. And now Sega Saturn sooner. What the heck's going on?

15:56Right. On top of this maybe forgivable Sega CD thing that happened, you know, a year or two before, like, this whole thing is just weird. So, on the back of this, the Saturn flops. It sells just over 9 million units compared to the Genesis, which sold 30 million units. And if you read the book, Consul Wars by Blake Harris, he spends a lot of time with Tom Kalinsky, the CEO of Sega of America, and interviews him.

16:25Tom and the other folks who are at Sega of America this time, like they're somewhat diplomatic, but they just kinda lambast the Japanese management of Sega at this point in time. They say that they at Sega of America fought against all of these decisions, that the Japanese parent company was jealous of Sega of America's success with the Genesis. Because the Genesis sold really well in America, didn't sell as well in Japan. No, all of the Genesis's success was in America, Europe.

16:54and South America. It basically did nothing in Japan. In console wars, the author draws this great analogy of Japan as the parent and America as the child. So shouldn't the parent be proud of the child's success? But in reality, the way that it actually was going on is that Japan and America were sort of sibling markets. And the parent's favorite child used to be Japan. And as the parent showed more favoritism toward America, The Japan leadership sort of retaliated and found ways to kick and scream. It's a, hey, you need to pay more attention to me. Yep. And Sega at this point, of course, is a Japanese company and the board is Japanese and at the end of the day, Japan wins here. So Tom and most of the rest of the team at Sega of America, they get super frustrated. They end up just leaving the company.

17:48including Steve race, who masterminded the whole aggressive marketing strategy behind the Genesis, you know, the Sega screen, the welcome to the next level. He goes to work for Sony to launch the PlayStation. Oh, yes, we'll talk much more about that in one minute. So Sega of Japan is kind of running the ship now at this point in time. They decide after a couple of years to give up on the Saturn, they launch another new internally developed console the dreamcast the dreamcast actually had some real innovations to it like it was the first true online console that shipped with internet connectivity built in it had the little slide out handheld thing that was like a little game boy that popped out of the controller that was super cool oh yeah the VM you that thing was cool and a bunch of the design philosophy made a lot of sense they were using commodity components instead of special silicon for it yep but

18:44Unfortunately, it launches against the PlayStation 2, which goes on to become the best selling console of all time and completely trounces it. So the Dreamcast sells even fewer units than the Saturn, and it's really sad after just two and a half years on the market. Sega ends up discontinuing the Dreamcast, announcing that they're getting out of the hardware business entirely. They're going to go to just being a video game developer and publisher.

19:13on other platforms on PlayStation, on the Xbox, etc. The company really just becomes a shadow of its former self. It limps along. And then finally, after a couple of years from kind of 2001, 2002, into 2003 of Sega just making games for other platforms, the company gets sold off to another Japanese public company, company called Sammy, that was a manufacturer of Pacinco machines, which is I like the Japanese equivalent of pinball machines. It's this sort of sad ending with a whimper for this once legendary Sega scream company. Right. You've got the exodus of all the talent. You're sort of still scratching your head a little bit about how it all fell apart so fast. You know, I started digging into why and how and what were the corporate transactions that actually happened around here. And David, I feel like there's more to this story because I pulled up pitch book to look.

20:10There are a lot more transactions around this company than you've sort of mentioned so far. Oh, are there? There are. Oh, if only there were a podcast that went and did really deep research on what actually happened here. Yeah. All right, listeners. Now is a great time to tell you about a longtime friend of the show, Vanta. AI has scrambled the whole security picture. It used to be that you proved that you were secure once a year on audit or a static PDF, then everyone would not and you're done.

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22:13Feels like there's so big things missing from the story. Yeah, you like that little story that I just told you, right? It almost feels high-gloss, apocryphal, and if you really stare at it, you're like, I'm not satisfied. That can't be, right? This is insufficient. Everything you say is exactly correct. The funny thing is, though, that listeners for you all listening, I bet most of you, if you knew any version of the story of the death of Sega, what we just told was the version you probably know. But...

22:41while it's not wrong, it's only one version of the story. And the other version is both way more charitable to Sega, the parent company in Japan. And also I think way more interesting in terms of like lessons we can take from it. So let's tell it. If you go listen to our two-part Nintendo saga, we talked quite a bit about Sega along the way. And especially in our first Nintendo episode, when we talked about Sega, We talked about them as this arcade company. And that's actually what Sega was. The home console business, the Genesis, the master system before it. These were like side project offshoots from what was otherwise an enormous and very successful arcade business based back in Japan.

23:34Totally it started as service games back in the like 40s 50s this merger of arcade game makers and arcade distributors you even had this story that you were telling I think we actually cut this from the Nintendo episode for time but on Parascope the Sega very innovative Sega game they standardized the unit of the quarter as what you pay for an arcade video game session yet the arcade industry it's lost a history now because Basically, it doesn't exist anymore, but it was bigger than the home console industry and nobody was bigger in the arcade industry than Sega. They were the OGs. They literally standardized the quarter, as you said. Now, that game, Periscope, came out in the 60s. This is before video games. This is what was called an electro-mechanical game. So there were like mechanical elements to this cabinet of

24:28Submarines and ships that moved around they were like plastic and cardboard and then you fired a gun that had like torpedoes that traveled on a light bulb path to hit the ships. That goes pretty cool, but it became so successful. Sega actually gets acquired in 1969. Yeah, I was shocked to see this in pitch, but I scrolled all the way down like I normally do when I'm looking at like private companies who raised money to see who their seed investors were and the first transaction for Sega is from 1969. Yes, the company that acquires them is Gulf and Western, which is a big oil company. Oh, yeah. The US, like, what the hell is going on here? Well, turns out at the time, Gulf and Western also owned Paramount Pictures, the movie studio. Oh, I've always seen that at the little, like, I don't think you see it anymore, but the little title screen. Yeah, when the movie is starting. Yep. So they acquire Sega and merge it into

25:26Paramount. The operations stay separate, and the like boards of Sega and Paramount stay separate, but within Gulf and Western, Sega's part of the Paramount Empire so much so that they take their two most talented Paramount executives and they put them on the internal Sega board within Gulf and Western. Do you know who those two people are? No. Michael Eisner and Barry Diller. What? Right.

25:54I had no idea. So, Michael Eisner and Barry Diller are like key parts of the Sega history. And all of this, all we're talking about, this is before Atari, this is before there is a home console business, this is before there's a video game business, period. This is how important Sega is in our case. 20 years before Michael Eisner becomes the CEO of Disney, and long before Barry Diller dreams up Interactive Corp. Yep, this is in the 1970s. So, we also talked on the Nintendo series about how Atari got acquired by Warner Brothers and this was as crazy like Atari, this video game company becomes part of this movie studio and then it becomes the biggest part of this movie studio. Warner Bros. was just copying Paramount and what they did with Sega. Isn't that so funny? Wild. So part of the strategy that Sega adopts during this time did like a truly international company because the arcade business was a truly international business. They're thriving in the US, they're thriving in Japan, they're thriving in Europe all over the world.

26:52They start not only building and creating these games, these arcade cabinets, they start building out their own arcade centers that they operate. They're like, we're going to make money every which way in this industry. So they're called family fund centers in Japan and Sega centers in the US. The Sega centers in the US change hands a few times go on to get rebranded. Sega always stays involved. These become timeout arcades, which is one of the biggest chain of arcades in the US.

27:22Whoa, okay. So Sega's got hundreds of these arcades that they are just printing cash out of because they're making money from selling the cabinets to their own arcades and other arcades. And then the arcades themselves are like hugely profitable businesses. Yeah, I mean, there's a lot of arcades that when you look at the side of them have a gigantic Sega logo plastered over it. I mean, clearly a company focused not just on home consoles but like making games.

27:49Yeah, when you say a company focused not just on home consoles, from the parent company's perspective, they'd rather not focus on home consoles at all. Now you can start to see another perspective on things here. In 1981, Sega publishes the game Frogger that Konami had made, but Sega published it. They made hundreds of millions of dollars on that thing. In 1983, right before the home video game console crash, led by Atari, They do 214 million in revenue, Sega does, as a division within kind of Paramount. Then when the video game crash happens at the end of that year, Paramount, just like Warner Brothers and Atari, they want out of the business, so they want to divest Sega. And one of the original founders from back in the day, that named David Rosen, and a Japanese entrepreneur of a company Sega had acquired, named Hayo Nakayama, they engineer

28:46A management buyout of Sega for the grand total price. I don't know if this is in pitch book of $38 million. This is the steal of the century. Yes, actually, there's a transaction in 1984. Looks like the investor name is CSK Holdings. Yes, that's it. So CSK Holdings was a public Japanese company that rose in a Nakayama.

29:10knew the management of, they financed this bio. They were like the pee shop. They were the sponsor of this transaction. Oh, interesting. And this is how Sega becomes an actual Japanese company, even though they were started by Americans to serve military bases back in the day.

29:27Right, okay, so holy bought out by golf in western then holy spun out yes, they bought the whole thing for only 38 million dollars like this is ridiculous this company which is legendary in the arcade industry did two hundred and fourteen million dollars in the year ended six months before this why did they value it so little this is the thing because of the home video game crash in america video games in general just became this toxic asset that nobody wanted to own especially you know Paramount and Warner Brothers was divesting Atari so the arcade business yeah got hit by the crash but it actually was fine and so this was just an amazing deal management bought the dip because they knew that they weren't actually really affected by this boy did they ever

30:16So then I think that was in 1984, they would go on to take it public. I think in 1988 on the Tokyo Stock Exchange. So now it's a publicly traded company. Yep, that makes sense because pretty quickly after the buyout, Sega gets back to their old tricks and they're crushing it. They're pumping out smash arcade hits like outrun. People might have heard of very famous racing game, Shinobi afterburner.

30:42Altered beast, too. It was a kind of beat-em-up brawler that we talked about on the Nintendo episodes. That was the original pack-in game before Sonic, with the Genesis. So, they're back to making hundreds of millions of dollars in their arcade business, both making the games and operating them in their own arcade centers. Nakayama, who was one of the two guys involved in the buyout. And Nakayama and Rosen had to get hugely wealthy from this.

31:07because of how unbelievably little they paid for the equity that by the time they IPO'd it would have been very valuable. Yes, I don't know the details, but I'm sure they did. Nakayama, he starts pushing the company. He gets worried about what Nintendo is doing and what he sees with the NES and he says we should also enter the home console business. It's like a diversification bet. Exactly. Rosen, CSK, the rest of the board.

31:33They're not that supportive because they're like doing great in our kids. I don't really care that much, but sure if you care about this, go do this. And that's when Nakayama goes and he recruits Tom Kalinsky to come in and run North America. It's kind of like a surprising success to everyone, the genesis in North America. There's the scene that we talked about in Nintendo part two where Tom comes over and presents his four point plan for dethroning Nintendo.

32:01to the board in Japan and the Japanese board is like, I don't know, like I don't really like this. Now it all makes sense. They're not dumb. They're just like, why would we risk pouring all this capital into the home console business when we're killing it in the arcades? And on the one hand, it's an innovator's dilemma. On the other hand, I have to imagine arcades stay a very good cash flow business for a long time. It's not like that was actually going away. Well, let's get into it. So Nintendo.

32:31and the NES and the Super NES and the home console business turned out was never really a threat to the arcade business because the way arcade technology and hardware worked was very different than the console cycle and the types of games were different in the arcades it was all iterative it was constant iteration Every game that came out was its own proprietary hardware cabinet and they were based on designs. They're called boards. There are arcade boards, but you could tweak it each time. You think about what Sega's pushing with all their add-ons to the home console. Of course, that would make sense to them. That's the way their R&D team worked. They'd have like a core base, you know, call it the system 16, which was Sega's kind of base 16-bit arcade platform that they based the Genesis on.

33:23Yeah, all these games I was just talking about Shinobi, Outrun, etc. They ran on that, but each new game, they tweaked the hardware a little bit. It was iterative. So they didn't actually have to think about we need to create a standard platform for developers to target for the next five years because every cabinet was its own self-contained system. So it's not really in their DNA to like...

33:46do a once every five plus year. This is the standard thing and we promise not to change it and we will create a bedrock platform for you developers. That's not really a thing. Yes. And so that means a couple things for the market that keep the arcade market not just viable but thriving. The arcades are where the most technologically advanced games are during this era because the hardware cycle is so iterative.

34:13The home systems, even the NES, as amazingly groundbreaking as it was, because the console cycles have to be designed to last so long, that's not where the latest cutting-edge stuff is. And so those games, the Nintendo games that they're making, you know, the way Sega counter-positioned against them with the Genesis, they're slow, they're not exciting.

34:36But that's what home console games became. They became these long adventures. These fantasy lands. Very different thing than you would do in the arcades. Makes sense. So, coming out of this era and then into the early and mid 90s, Sega's arcade unit is just killing it. They had those hits in the 80s. Everybody got super wealthy. And then, they start really pushing the envelope on technology. There was a ton of innovation coming out of Sega. They developed The first real modern, great 3D games, we all think now of Super Mario 64 as being the first 3D video game that consumers used and loved. Actually years before, Sega put out the Virtua series in the arcade, so this was Virtua Racing, Virtua Cop, and most importantly, Virtua Fighter. Now this game, Virtua Fighter, which was a fighting game, it used

35:343D polygonal technology. If you think back to 16-bit Super Nintendo games, they're flat, they're 2D. 3D games like Think Mario 64, you're running around in a 3D world. All of the environments and characters are built using polygonal math. We talked about this a lot on the Nvidia episode. Right. Triangles. Triangles. This is new. Sega is the one that actually brought really good games to market with this and it was all in the arcades.

36:02So Virtua Fighter when it comes out in 1993 is so popular, Sega sells over 40,000 Virtua Fighter cabinets worldwide at a price of like $10,000 plus per cabinet. That's half a billion dollars in revenue on Virtua Fighter. Wow. So it's a huge win financially for the company. Even more so though, it's so impactful in the video game industry once Virtua Fighter comes out.

36:31Everybody realizes, hey, 3D polygonal games are the future. And what year was this? This was 1993, right as Ken Kudiragi and the team over at Sony are working on their standalone PlayStation. They've broken up with Nintendo. They're going to come to market with their own console. And this is pivotal.

36:56I want to read now from the Wikipedia page for the PlayStation 1 console. After Sony witnessed the success of Sega's Virtua Fighter in 1993 in Japanese arcades, the direction of the PlayStation became quote, instantly clear, and 3D polygon graphics became the console's primary focus.

37:17Sony Computer Entertainment President expressed gratitude for Sega's timely release of Virtua Fighter as it proved, quote, just at the right time, that making games with 3D imagery was possible and that this was the direction the PlayStation should focus. So, the impact of this is huge. Arcades remained viable through the 90s because they had the technological edge.

37:46But now Sony is going to come enter the market and they don't care about our kids. They're going to bring their technology and financial firepower all to the home market and their goal now is to make a machine that can rival the arcade technology in the home market. And they have the balance sheet to subsidize it so they can take a strategy of coming into the home with very, very good technology at a price point that consumers could afford.

38:16Yep. So here we are now. The end of 1993 into 1994. Sony has announced that they're coming out with the PlayStation. They're all in on entering the video game market. They start going around and talking to all of the non-saga arcade manufacturers, Namco, Midway in the US, Konami, and they start convincing them to bring all of their new arcade games directly to the PlayStation. When it first comes out, in end of 1994 in Japan in the 1995 in the US. It's an arcade killer. That's what it is billed at. It becomes so much more than that over time. It's Grand Theft Auto, it's Final Fantasy, it's all that. But in the beginning, the vision for the PlayStation was we're going to take the technological firepower of the arcades and we're going to bring that in a way that Nintendo can't and Sega won't into the home market.

39:15And of course all the other arcade manufacturers love this strategy. Right. We can benefit from writing the Sony platform into the living room, but Sega is going to get caught in the wind here. Because they have a home console that's making it so that they can't go aligned with another home console. Namco doesn't have a home console. Konami doesn't have a home console. Midway doesn't have a home console. So before the PlayStation launched, the arcade industry was back up to about $7 billion a year globally. And a huge portion of that was controlled by Sega. After the PlayStation launches, by the end of the decade, it's down to $2 billion. So it drops by 60% in just a few short years, and it's all due to the PlayStation. So the PlayStation basically killed Sega's arcade business and their console business. Yep. That's what happened. Wow. So now let's go look at this kind of

40:14original console wars book type narrative about what happened we have a whole different perspective now all this crazy hardware schizophrenic add-ons these are like panic responses to the coming tsunami of Sony not just worrying about the home market but worried about their arcade dominance as well huh and i have to imagine at some point Sega of Japan lost their desire to make a great competitive home console, because that was the thing that was preventing them from being able to be in business with Sony. Now, it doesn't mean that they're going to stop making consoles right away, but it does sort of plant this seed of, huh, we have a little bit of a strategy conflict here where we either have to be all in and winning in consoles or we just need to make games. Yes, but we can't really

41:07be on a seesaw, I'm kind of trying to do both and have a foot in both worlds. So here's what happens. In September, 1994, right before this crazy 32X thing comes out, Sony and Namco, when Namco was Sega's biggest rival in the arcade business, they come out with a pretty huge industry-changing announcement. They're going to partner together to release a quote-unquote virtual fighter killer arcade game called Tekken. Folks might recognize the Tekken series. Well, no idea. Tekken is so much more than Tekken. The game is going to come to the PlayStation when it launches. It's not out yet, but yeah, like, great. Okay. We all remember Tekken. You played on the PlayStation, and I think it was an exclusive, et cetera. But it's also coming out right now in September, 1994 in the arcades. And in fact, it's going to be running on Namco's awesome new

42:05System 11 arcade board platform that they have developed together with Sony. And guess what? Further surprise, the System 11 arcade board developed with Sony is the PlayStation. Whoa. So this is just the ultimate knife in Sega's back.

42:25They're just basically shipping playstations inside of these arcade cabinets. Yeah, it was the PlayStation hardware. Like, there was some buffs to it and whatnot, but Namco and now for the soon, all the other arcade guys, they're gonna be like, oh great. We're moving all of our development platform for the arcade industry to the PlayStation platform. The technological bleeding edge is now gonna be, yeah, also in the arcades powered by the PlayStation, but in the home powered by the PlayStation. Wow. What a Trojan horse.

42:55So now, Sega is like, oh shoot. We are screwed. We need to scramble the jets and just do anything we can to try and stave off this apocalypse. So they launched the 32X. Seems really dumb, but they got to do something like, okay, we need to get into market right now with a 32-bit system to just try and preempt Sony here in the PlayStation launch.

43:24then they massively accelerate the Saturn launch. Why did they do that? The same thing. They're just trying to do anything they can think of to steal some of Sony's thunder here. Yeah, makes sense. The Barbarian is already through the gates on the arcade side of the business because Namco's shipping these System 11 arcade cabinets today and it's right at the gates coming next year with the PlayStation.

43:50It's funny how much in our Nintendo episode the conflict was Sega versus Nintendo, but the death of Sega really is against Sony. Yes. So that brings us to the very famous E3 conference in May of 1995. And this is maybe the most incredible video game industry event of all time. We referenced it earlier in the show, but we're heading into the conference.

44:19Sony is expected to announce the US release date and pricing of the PlayStation at this conference. People expect it's going to be in the fall. You don't kind of know what's going to happen. Sega, they need to do something. And so this is when Sega of Japan tells Kalinsky and Sega of America, do the surprise launch. Get up there, announce the Saturn. Just do it. Even though the ecosystem isn't ready, the hardware is ready, so we're shipping it. We're shipping it.

44:45So Tom does that. He dutifully goes up. He announced his, oh, forget Saturn Day. You can buy the console now. It's in limited quantities. It's select retailers for a price of 399. And he's basically doing this because Japan has said either you are doing this or we will find a new CEO for Sega of America. Who can do this? Yes. 399. That is the Sega Saturn price point available today. May 11th, 1995.

45:14So Kalinsky finishes his speech. He walks off stage. They usher everybody out of the room. They turn it over. They get ready for the next keynote of the day, which is going to be Sony. Sony keynote starts a couple hours later. Olaf Olipson, who's the president and head of all of Sony America, so like not just the PlayStation, all of Sony's businesses. He gets on stage. He starts giving his presentation. He says that the PlayStation will release in the US on September 9th.

45:431995, so Sega's like, Phew, great. They're not moving it up. We're gonna beat them to the punch. We're live today. We got a four-month head start. Let's go. And then Olaf invites the new head of Sony computer entertainment America, one Steve race, formerly of Sega of America, up to the podium to give a quote-unquote brief presentation. He walks slowly up to the podium.

46:13He's got a large stack of notes. He places them down on the lectern. He shuffles them around. He waits a beat. He's ready to give his big speech. He looks up. He looks at the audience and he says 299 and then he picks up his notes and he walks off stage. And this is I think most people in the industry I think would agree that this is the greatest moment in all of video game industry history.

46:43Right, of industry announcement type things. Yes. All right. So that's Sony PlayStation 1, 299, for by far the most sophisticated system on the market. We will link to the video of this in the show notes. It's on YouTube. I mean, people still watch this to this day. The reaction is amazing. At first, there's silence because people like, what did he just say? What does this mean? What's going on? And then the crowd starts cheering. And then you can hear after about like 20 seconds or so when This really sinks in of what this means. People go nuts. There's like another wave of cheery. It's unbelievable. It's like that last wave is all the developers realizing, oh my god, we are going to print money because there's going to be so many people buying this thing. This exact moment in the afternoon of May 11th, 1995, is the death of Sega. Because let's go back and think about the three.

47:40key constituencies in the video game home console business kind of flywheel. You've got the consumers why on earth would any consumer go buy a Sega Saturn today on May 11th on its launch day that has no Sonic game has only six games total and it costs 399 when you now know that the PlayStation which is far superior is going to come out just four months later they're going to have perfect ports of all the latest and greatest arcade technology video games, and it's going to cost less. Wow. You're not going to buy a Saturday. So that's the consumers. Then the retailers. The retailers are so mad at Sega. Sega just completely ruined all of their holiday season planning because

48:31For retailers, Q4 is everything. And why are these consoles launching in the fall in the US so that it can be ready for the holidays? Sega just screwed all this up. And now more importantly, they've got units on trucks, on route to their stores that they know they're not going to be able to sell now. So they are so mad at Sega. I think it was KB toys, which then was a big franchise in America. They drop Sega entirely. We're not carrying your stuff anymore. Goodbye. You're gone. And then you've got the most important piece, the developers. All the third party developers who are sitting there at E3 watching these keynotes, they're like, wow, we're gonna make a ton of money on Sony. And Saturn has no chance of building a meaningful install base. So like, if I was planning on developing games for the Saturn, I am now canceling those plans. This is just the worst thing that could possibly happen to Sega and the Saturn and the arcade business.

49:29Now listeners, as you can imagine, there is a tough path that they have to now traverse to get to the 2023 saga that we're going to talk about and what they look like as a games business today. David, I have a couple of stories that I don't think you know about how they made that transition. So I'm curious to know if I will stump you with that or not. All right, listeners.

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50:47because they've spent more than 20 years building the operational backbone of the enterprise. The workflows, governance, approval, security controls, and institutional knowledge that power how work actually gets done across IT, HR, customer service, finance, and security. Service now already runs more than 100.

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51:27So, if you're trying to turn AI ambition into real business outcomes and make it work safely, securely at scale, go check out servicenow.com slash acquired and tell them that Ben and David sent you. Okay. So, David, here are a few things that I was curious if you knew about. So, I planted the seed earlier with the idea that some people personally accumulated a lot of wealth through Sega. One of these people was Isaiah Okawa. Yes, the chairman of CSK, right?

51:57Yes, exactly. And then ultimately became the chairman of Sega. So in 1999, he had loaned Sega $500 million. I believe personally, in 2001, the writing was on the wall. He was coming to the end of his life. He actually forgave Sega's debts to him ahead of his death and returned $695 million worth of Sega and CSK stock.

52:23which basically was the bridge that Sega needed to transition a massive shift from the Sega that we've been talking about this whole episode to just being the game creator that they are today. Yeah, because all of this R&D that was required to go into these new consoles, the Saturn, and then we just talked about how the Saturn basically got the floor wiped with it by Sony and the PlayStation 1.

52:49Sega would then turn around and pour a bunch of effort into the Dreamcast. The same story would happen, but even worse, the Dreamcast sold less than the Saturn and the PS2, of course, goes on to become the best-selling console of all time. It takes hundreds of millions, if not billions, at dollars, in R&D to create these consoles. Right. They're just destroying their cash reserves. Yeah. You would think when the PlayStation comes out and basically creates a giant sucking sound that takes all of the business and players in the arcade industry and brings them into the home console with the PlayStation, that Sega would also get decimated in the arcade side of their business, which was the golden goose. They do, but they kind of get a stay of execution for a couple of years. Thanks to this partnership that they do with the Japanese developer, Altus, to launch purekura machines. So yes, the core gaming experience of the arcades.

53:46does get totally gutted and Sega along with it. But almost like Nintendo and Pokemon, this pure Akira thing, these are photo booth like selfie booths. Oh, I did read about this. I just didn't know what it was called. Yeah. This kind of becomes sort of the origin of the selfie phenomenon that of course started in Asia and then like moved to the rest of the world. Sega was right there at the beginning of this. So the photo booths in the late 90s make over a billion dollars in revenue that say a what plugs into their quote unquote arcade business division now this is not the arcades by any stretch of the imagination it makes sense though it's the same distribution channel it's kind of the same locations as arcades exactly but unlike cutting edge technology in the arcade video game business there's nothing defensible about this it's a one time cash grab exactly so once

54:42both the FAD subsides and competition springs up. By the end of the decade, Sega no longer can continue in the hardware business on any front. So what do they become? Well, they become a games publisher. You can get Sonic on Nintendo platforms and on the PlayStation and on Xbox and that's great. They make mobile games. I remember in 2008, the very first iPhone game that I had was Super Monkey Ball, which was a Sega game. Yep.

55:11Actually a really good game, super fun puzzle game. Yeah, and it was perfect for the iPhone handheld device with accelerometers. Like it was this natural fit on mobile as people were trying to explore that form factor and figure out what it should be. In fact, it was, I believe in one of the original Apple iPhone OS app store keynotes to show off what games you could make, what types of experiences you could do on this device. And so we keep talking about the Sammy. What was the Sammy transaction and what was Sammy before Sega Sammy?

55:41Yeah, so Sammy was and is a Pachinko machine manufacturer an operator in Japan beyond the scope of this episode But Pachinko is kind of like pinball used to be in the US It's like gambling meets pinball and it's like much smaller than pinball. It's like a small vertical type thing Yeah, you know on the one hand it's sort of gaming Ask on the other hand. It's also like a slot machine just like pinball was back in the day in the US So that's what Sammy was. They had made some video games in the past. They had a small video game division. And so they acquired Sega and merged that into their video game division. And it's fine. It's still a public company. You could say maybe at the bottom end of the majors or the top end of the sort of like mid-level game publishers out there. It's fine. Yeah.

56:29And Pitchbooks got this around 2003 for the Sega and Sammy merger and they've just been Sega, Sammy publicly traded ever since. More stats from Pitchbook today, they're a $4.3 billion market cap company. If you back out their cash, they have an enterprise value of about $3.6 billion. Last year, they did $2.7 billion in revenue. So clearly, the market doesn't think much of them with a revenue multiple of $1.3.

56:57It's a little bit of like a zombie company. Yeah, you know, this is a good spot to transition to analysis here. I think there's a couple interesting things to talk about in playbook and then we have a fun sort of way to end the episode. One of the things I want to talk about is despite all of these machinations and mistakes, they do have some pretty great IP in the company. The Sonic movie, it's no Mario movie, but it did pretty well.

57:25People still love Sonic the Hedgehog. The Akusa franchise is strong. There's lots of other franchises within Sega. Is there almost I'm wondering like a LVMH Bernard Arno style takeover opportunity? Like could you come and acquire either the whole Sega Sammy company or the Sega IP out of it and like do it right? You know, there's so much more that could be done with this stuff. I don't think so. I mean, my take on this whole thing is that Sonic was a one trick pony.

57:55and that they never really found effective way to expand the franchise. They came out with a bunch more stuff that had Sonic on it, but I never wanted to play 3D Sonic the way that I wanted to play the original Sonic the Hedgehog side-scroller game. It feels to me like there's a lot of nostalgia to play with, but it didn't really create any durable extensible IP or a gameplay, frankly. Well, right back to the difference between Sega and Nintendo.

58:23and the games and the difference between Miyamoto and Sonic Team. You know, Sega's DNA, this is the whole point of this episode, it was the arcades. The type of game you make for an arcade is very different than the type of game you make for a $60 packaged good home console. Sonic was the perfect arcade style game. That first level in the first Sonic was so good. And even the subsequent 3D stuff like Sonic Adventure and Beyond.

58:52The first level of Sonic Adventure for the Dreamcast is so good. It really is like you play it and you're like, wow, this is 3D Sonic, this is everything I remember. The first level is in like an island setting and you're like chasing a whale, like running around at Sonic's speed and doing 3D loop to loops. It's super fun. But the problem with these games and with Sonic is it's super fun for five minutes. Yeah. And then you're like, okay. I'm done. Whereas Mario and Zelda...

59:21It's not as fun in the first five minutes, but you can play it for 50 hours and lose yourself in it. Since we did most of the kind of analysis commentary in the story, let's just ask the question, what could have saved Sega? And this is where it's probably worth sharing the Jim Clark story. Yes. So this is a great excerpt from console wars. And I had no idea. I mean, we have talked a few times about Netscape and Jim Clark and SGI and how the internet almost happened on N64s with Mark and Jason and Jim Clark together. And you may know that the N64 was based on SGI's architecture. You needed an expensive SGI workstation to create the amazing graphics games. A big reason why the best N64 games were first party and there weren't a lot of third party games. Right. But the way that that came about.

1:00:19is crazy. It was actually Tom Kalinsky, the CEO of Sega America, who wanted to do the partnership with SGI. He saw the potential in the cutting edge chips and after the potential Sony partnership that we referenced earlier fell apart between Sega and Sony. He came back to Sega of Japan with a pitch saying, I just met with Jim Clark. I really think we should do something with SGI. I think our next generation console should be powered by SGI and Sega of Japan got back to Kalinsky and said, no. And when Kalinsky pressed them and said, why it's a no brainer, they said, the chip is too big.

1:01:04and Kalinsky was like, what? This doesn't make any sense. And they were like, that's our decision. And so he had to have this really hard phone call with Jim Clark saying, I'm sorry, man, I actually don't have a deal for you here. Japan is against it. And so Jim Clark goes, what am I supposed to do now? And Kalinsky in this incredible moment of frustration where he seems half a foot out the door, looks in the phone book, looks up Howard Lincoln's phone number and says you should call Nintendo of America.

1:01:33which I can't believe that actually happened. I know. It's so crazy. But again, you know, understanding what we know now from the Sega story, it's not just that Sega of Japan was being really dominant here. Right. That was a reasonable business decision. Because at that very same time that Tom was calling up Japan and being like, oh, we're going to do this thing with SGI, the Sony Apocalypse was coming in the arcade business with the system 11 and Namco and the PlayStation and I can totally understand say give Japan being like Look doing this SGI thing. That's not what we have time for right now Yeah, I also think there was probably some kind of like not invented here sentiment where it has to happen in Japan within Sega's walls in order to be a viable strategy It is a little weird

1:02:26you know, it's not like they already were thinking we should just be a software business because they did have the dreamcast after this. To me, it feels more like a lack of willing to partner than it does a sort of business model conflict. Had it happened a couple of years later, you would have been like, okay, clearly you should get out of the console business. And so don't invest in new hardware partnerships. But I think this is just we don't know those guys. We don't trust those guys. So we're not working with them thing.

1:02:53Who knows if it could have saved Sega, but maybe. That's probably the closest thing that I can think of, too. Like, had that happened, probably still wouldn't have saved Sega, but at least the Dreamcast might have had more of a chance of success. Maybe. We'll never know. All right listeners, now is a great time to talk about one of our favorite companies, Statsig.

1:03:16Yes, there is a reason why the best product teams rely on Statsig, whether they are iterating on their core product features or shipping AI-powered experiences at scale. Yeah, in the crazy speed of today's AI world, shipping fast is just table stakes now. It's basically trivial to build and deploy your app constantly.

1:03:38The real advantage is how quickly you learn what changes actually created value for customers. And how fast you can use that signal to guide what you shipped next. This is where Statsig comes in. It brings experimentation, feature flags, and product analytics into one unified system so teams can ship safely, test rigorously, and directly link what they changed to how users actually behaved. So if you want to make learning your competitive advantage, whether you're building new AI experiences or just evolving your existing core product, go to statsig.com slash acquired to get started. Carvouts. Carvouts. Let's do quick carveouts. I have one funny story before giving my carve out. This is a thing that also got cut from both last episode and I'm not letting it get cut from this episode. The Sonic origin story is hilarious. In a interview years later, Neyoto Oshima, who is one of the creators, I think he was the designer of Sonic, he was asked, how did you come up with Sonic? This blue hedgehog. Why does he look like that?

1:04:37And his answer, he just says, well, I put Felix the cat on the body of Mickey Mouse. That's right. And I was reading that. I couldn't believe it. And you look it up and you're looking at Felix the cat and you're looking at his eyes and his head shape and you're like, oh my God. It's Felix on Mickey dyed blue with sneakers. Yes. It's ridiculous. Uh, to your point about Sonic while being beloved isn't really like the super deep IP. No.

1:05:05Kalinsky and team gave it a good run, but man, it was thin all the way around. It was. All right. What do you got on carveouts? My carve out, I want to re carve out your carve out from a couple episodes of Darryl Mori on Invest Like The Best. I listened to it after you recommended it. Darryl, now the GM and president of basketball operations at the Sixers, formerly the GM of the Houston Rockets. He's just brilliant and so fun to listen to, whether you care about basketball or sports at all. I mean, he was a computer science.

1:05:35Major, like, he's very, very interesting. And Patrick is just such a good interviewer. It really is a masterclass in how to conduct a truly interesting, explorative discovery-based interview. And I learned so much from it. I really enjoyed it. Yeah, so good. Okay, I have three. They're gonna be fast. One is, my God, if you are not watching this season of succession, it's the best television I've ever seen. Just remarkable storytelling. Two.

1:06:03I'm keeping a close eye and I suspect many of you are as well in the next month Starship is scheduled to launch and so nice SpaceX launches always sort of our who knows on the date and Elon things always slip but it is on the launch pad They're doing lots of pre-launch inspections and tests and it is gonna be so freaking cool to watch that thing do its first launch and then three I said this to David I don't know David you watched it yet six days to air I haven't yet All right, if you like this and you like South Park, you will love that. If you like this and you like watching creativity and action, but you're not so sure on South Park, you may still love it. It is a documentary about the process of conceiving of a South Park episode idea on a Thursday and then having it air the following Wednesday and the unbelievable six day turnaround. There's just nothing more special than watching creativity and action.

1:07:02I think the documentary is like 10 years old at this point, but a pretty special view into their process. Nice. We could learn some stuff for acquired. Lot we can learn. All right, listeners, that's it. Thank you so much for joining. You can become a deeper part of what we do here at acquired by becoming an LP. You will gain access to our LP-only Zoom calls every couple of months or so.

1:07:23and you will help us pick at least one episode per season. Our next episode is actually LP selected, so if you join now, you will get in on the next one. You can join at acquired.fm slash LP. Check out our interview show ACQ2, available in the podcast player of your choice, free and public.

1:07:43Join the Slack. The Slack has been a critical part of our research recently since many of you are experts in the topics that we are covering. So lots of great gaming discussion going on there. And if we missed anything in this episode, let us know acquired.fm slash Slack. And with that listeners, we will see you next time. We'll see you next time.