How Sega Lost the Console Wars

You might know that the Dreamcast’s failure led to Sega exiting the console market. But did you know that those days almost spelled the end of Sega in its entirety?

This is the tale of Sega’s meteoric rise, their downfall, and how one man’s generosity is the only reason the company still exists today.

 

From Slot Machines to Consoles

The Sega faithful will no doubt be aware of some of the company’s history, at least starting with the Master System in the mid-to-late ‘80s. But Sega’s history stretches back several decades prior, with twists and turns that eventually birthed the company we know today.

During the final years of World War II, American businessman Irving Bromberg saw an opportunity: the war’s onset had meant an increase in personnel at various American military bases, accompanied with increased demand for stuff to do during downtime. Bromberg established Service Games (or Sega, for short), Hawaii to cater to this need by selling them slot machines.

Service Games would go on to expand to Japan after slot machines were outlawed in U.S territories in 1951. The company shut down in 1960, and two Japanese companies, Nihon Goraku Bussan and Nihon Kikai Seizō, were formed to replace it.

Goraku Bussan would eventually merge with Rosen Enterprises, forming Sega Enterprises.

Sega’s story begins proper in 1983. Sega had been well-established at this point, having cut their teeth on a successful arcade business in the decades prior. The early ‘80s, however, saw the arcade scene decline in prominence, leading Sega to transition into the console market with the release of the SG-1000. Its unexpected success wowed the company, and they would delve further into console development in the following years.

The SG-1000 II was released in 1984, and it was a tweaked model that replaced the hardwired joystick with detachable controllers. That same year, Sega would be bought out by CSK Holdings; its chairman, Isao Okawa, would also become the chairman of Sega itself. Though his most important role in Sega’s rich history wouldn’t come for roughly 17 years, his impact on the company would be remembered more than 23 years after his passing.

By 1984, however, Nintendo’s Famicom had closed the gap and was beginning to surpass Sega’s machine. Faced with stiff competition from other console makers, including Tomy and Bandai, Sega responded by releasing the Sega Mark III, better known as the Master System, in 1985.

Though successful in Europe and Brazil, the Master System failed to make any real headway in North America and Japan, where Nintendo was dominating the industry. Nintendo’s exclusivity contracts meant that there was a lack of third-party developers able to support the Master System. In the west, Sega only had two such companies — Activision and Parker Brothers — to help them out. Likewise, its marketing department was run by only two people, leaving the Master System with a major disadvantage against Nintendo.

With their continued difficulties in mind, Sega began development on its next system as soon as the Master System had been completed.

 

Genesis Does What Nintendon’t

Sales for the Master System had been flagging by 1987, and Sega decided they needed some outside help. Sega sold the system’s distribution rights to toy company Tonka, believing that if Nintendo could succeed by marketing the NES as a toy, then so could they with the Master System.

Tonka’s lack of experience and poor performance, however, resulted in Sega looking for other distribution partners for the Genesis. Though initial talks seemed promising, Atari would ultimately decline the distribution rights. Soon afterwards, Atari president Michael Katz joined up with Sega, heading up the Sega of America branch to help take on Nintendo.

You can’t sell a console on bluster alone — you need to put your games where your mouth is. Katz understood this, and tapped into the world of sports, securing the rights to use NFL quarterback Joe Montana as the face of several sports games released on the Genesis — something Katz cites as the thing that really helped the system take off, and not just Sonic.

Katz also knew that they needed a strong hook for the system, and with Nintendo hoarding all of the hottest arcade ports as exclusives, decided to lean on celebrity endorsements as the next best thing.

Despite this early success, Katz’s tenure at Sega was short-lived. Katz had failed to move a million units in the system’s first nine months (something he cited as an unrealistic target), and Sega of Japan CEO Hayao Nakayama ultimately replaced him with Tom Kalinske, who had a much longer run from 1990 to 1996.

This wasn’t Nakayama’s first attempt at courting Kalinske, either. He’d known him since his days at Matchbox, and once asked Kalinske to help handle distribution of the Master System in Europe, only to be turned down due to the system’s lack of any real advantages over the NES.

Nakayama, however, didn’t give up, and eventually went as far as to track Kalinske down to Hawaii, where he convinced him to go to Japan to take a look at Sega’s new 16-bit technology. Kalinske obliged, and this time, fell in love with what Sega had to offer, deciding to join them under the condition that he have the freedom to make decisions for Sega’s western branches.

In spite of this, Kalinske’s first proposals at a board of directors meeting were met with utter revulsion by all present, even Nakayama himself. Kalinske presented a multi-step plan to success: reduce the Genesis’s price tag, establish a US-based development team to make games catered to western audiences, ramp up an aggressive ad campaign that made fun of Nintendo, and replace the system’s pack-in game, Altered Beast, with Sonic the Hedgehog. Despite Nakayama’s displeasure, he ultimately approved the plan, upholding his promise to allow Kalinske to call the shots over in the west.

Sega’s bid to overtake Nintendo in the west led to some novel marketing strategies, including sponsoring rock concerts and having college students go to men’s dorms and fraternity houses to plug in and play the Genesis; they also ran ads on MTV. The company’s goal was to target the male audience, and they succeeded.

During the 1991 holiday season, the Genesis outsold the SNES at a 2-1 ratio, and by 1992, they had achieved 60% of the North American market. The Game Gear was also doing well at this time, thanks to some of the wildest marketing you will ever see. Kalinske’s plan was a success, helped by the fact that the Genesis had a two-year lead over the SNES, and so had a bigger library. Though the SNES would fare much better in Japan, and eventually overtake the Genesis worldwide, gaming at that point was still changed forever. Nintendo had a serious competitor, and could no longer dominate the industry the way they once did.

This success didn’t come without a cost behind the scenes, however. In truth, Nakayama was upset at how Sega’s Japanese branch failed to capture the same results at home that Kalinske had achieved abroad. He made that displeasure clear — sometimes violently so — on a weekly basis. This caused resentment against Kalinske to fester amongst his Japanese colleagues, something that he believes ultimately lost him the support and freedom to make his own decisions. Later, promising business opportunities would pass Sega of America by, with Japan overruling major decisions.

 

The Cracks Begin to Show

The Sega Genesis, from its conception, was designed with the ability to expand in its functionality. With CD-ROM technology on the rise, this took the form of the Sega CD. Development, however, was troubled; the slapdash use of cheap hardware led to severe issues. As senior producer of Sega of America Scot Bayless put it, “when I say severe, I mean units literally bursting into flames.”

It’s also here that Sega of Japan’s fickleness and desire for control began to rear its ugly head. Out of a desire to prevent leaks, they refused to send any development kits to Sega of America, only giving them preliminary design documents. The US branch only received a crippled “dummy” unit; it wasn’t until the last minute that Sega of Japan sent over functioning CD units.

Despite those cost-cutting measures, the Sega CD launched at a price of $299 USD, which was not only a barrier to entry (it cost more than the Genesis itself), but a loss for every unit sold.

Initial sales were promising; the Sega CD moved 200,000 units in its first three months in Japan. The next 200,000, however, would take a whopping three years to reach, owing to the Genesis’s low sales in the region. The Sega CD was ultimately a flop, lacking much in the way of must-play games. Its initial library was dire, with only five titles published by Sega in the add-on’s first year in Japan.

Outside of a few acclaimed titles like Sonic CD, Lunar: The Silver Star, and Hideo Kojima’s Snatcher, the Sega CD’s meager library consisted mostly of FMV games and Genesis ports that really didn’t need to exist, beyond CD-quality music. Compounding this was the device’s very nature, which as former Sega of Europe development director Mike Brogan put it, could only “sell into the existing customer base.”

The Sega CD did go down in history for one more major reason: it holds the dubious honor of being the original home of FMV game Night Trap, which was so controversial that it partly led to the formation of the ESRB.

The Sega CD’s failure didn’t deter Sega, however, and in 1994, the Genesis saw another add-on: the 32X. At the beginning of that year, the market was in a complex position. In Japan, the Genesis was handily outsold by the Super Famicom. Much of Sega’s success at the time came down to the Genesis’s significantly better performance in the west. Further complicating matters was the fact that the Atari Jaguar had just launched a few months prior, at the end of 1993.

In early 1994, Nakayama called up Sega of America and ordered them to develop a response to the Jaguar, and to get it done as soon as possible. Sega of Japan recognized two things from the market conditions at the time: first, that the Genesis’s loss against the Super Famicom meant that they were better off focusing all of their attention on the then-upcoming Sega Saturn instead in this region. And second, that the Genesis’s western success was what propped the whole company up at the time. When Sega of America argued that the Genesis’s lifespan could be stretched out just a bit further, Sega of Japan listened, leading to the birth of the 32X.

This, unfortunately, turned out to be an even worse idea than the Sega CD; not only was Sega focusing their attention on the wrong rival, with the Jaguar being arguably the biggest hardware flop in gaming history, the 32X shared hardware components with the then-upcoming Sega Saturn, diverting their resources and attention across multiple platforms. The device itself, like the Sega CD, had to be pared back to cut costs, making the final product impractical when it finally came to market. And it did so in the west on the same day that the Saturn hit store shelves in Japan, something Scott Bayless says made the company “look greedy and dumb to consumers.”

The 32X initially launched for $159.99 in 1994, but flagging sales saw the price cut down to $99 a year later. By the end of the 32X’s brief life cycle, stock was being cleared from stores at prices as low as $19.99.

The add-on ultimately succumbed due to a lack of games and mixed messaging that threw developers and consumers alike into confusion, as the Saturn was also due to arrive the following year. Only 40 titles were released for the 32X during its lifetime, and due to being rushed to meet the launch window, many of these games failed to show what the add-on was capable of and why it was worth the investment.

Making matters even worse was the fact that a handful of games — including a 32X port of the aforementioned Night Trap — required both the Sega CD and 32X installed on a Genesis to function. Though only five titles of this nature were ever released, the whole concept sums up Sega’s lack of a cohesive vision and its confusing marketing. According to Bayless, no one at Sega at the time was willing to stop and think about how multiple bad ideas had been rushed to market, let alone speak up about it.

This mixed messaging and saturation of devices ultimately did the most long-term damage to Sega and its reputation, turning off consumers from later consoles — after all, why buy a Sega system if it was going to have a meager library and soon be superseded by a new device? Sega, unfortunately, failed to learn from these mistakes — mistakes that had cost them money, credibility, and goodwill.

 

A Shadow-Dropped Console

The development of the Sega Saturn saw Kalinske continue to butt heads with Sega of Japan, this time over hardware design. At the time, Kalinske’s main responsibility was on pushing Sega’s software because when it came to hardware, he was simply to do whatever they told him to do. Nevertheless, he was presented with a prime opportunity by Silicon Graphics. Its chairman, Jim Clark, was personally acquainted with Kalinske, and contacted him to show off a chipset that seemed perfect for a game console. While Kalinske agreed that the tech looked promising, Sega of Japan turned down the deal, saying it was too expensive and difficult to manufacture.

During this time, Sony, having been burned before by Nintendo, approached Sega with a deal: make a joint platform where they would share development costs and losses, while each benefiting from whatever games released for the system. This was, again, an idea that Kalinske found promising, and one shot down by Sega of Japan. In an interview with GamesIndustry.biz, Kalinske would highlight this choice as “the stupidest decision ever made in the history of business.”

Both of these rejections proved to be critical mistakes; Silicon Graphics would go on to work with Nintendo instead, resulting in the Nintendo 64. Sony, meanwhile, decided to go solo in making their new console, with the PlayStation’s massive success setting the foundation for an even more crushing victory the following generation.

Sega’s third major blunder with the Saturn was betting on 2D over 3D, believing that the future was in enhanced and polished sprites and animations. But when Sony revealed the PlayStation’s 3D capabilities, developers jumped ship en masse to focus on pushing polygons. By this point, the Saturn was already too far along in development to course-correct, and the best that could be done was to add a second Hitachi SH-2 CPU to handle 3D processing.

Aside from making the right call to bet on 3D for the future, Sony’s PlayStation also had another distinct advantage: its hardware was much easier to develop for. Its developers also received better development kits and support, giving the system a stronger slate of launch titles.

The Sega Saturn’s release in Japan saw a brief reversal of fortunes — enough for Kalinske to claim in a leaked 1996 email that “we are killing Sony”. The Genesis had long since lost the console war against the Super Famicom, and rather than divert their attention like the western branches did (the 32X didn’t even release until after the Saturn in Japan), Sega of Japan threw its weight behind the Saturn, leading to a strong opening and lead over Sony — though the PlayStation would quickly catch up.

The American release of the Saturn, on the other hand, is an entirely different story. Nowadays, shadow-dropping games can be viable because of the online nature of game presentations and digital distribution. Shadow-dropping an entire console, on the other hand, presented Sega with even more challenges and obstacles they couldn’t overcome.

Kalinske had intended to launch the Saturn in early September of 1995. Sega of Japan, on the other hand, wanted a head start over the PlayStation, and forced Kalinske to move up the launch several months. At the very first E3 on May 11, 1995, Kalinske announced that the 30,000 Saturn units were immediately available at select retailers for a price of $399.

The consequences were immediate and disastrous. Sony executive Steve Race would later step on stage and make history by simply saying “$299” before leaving, confirming that the PS1 would drastically undercut its rival. To make matters worse, the Saturn had only six games on launch day due to third party developers targeting the original September release window. Retailers were also shocked by the announcement, and those excluded from the initial batch of Saturn units responded by refusing to carry the system and its games in any capacity.

 

X-Treme Disorder

As with the 32X and Sega CD before it, the Saturn suffered from a lack of big killer apps. And unlike the Sega CD, there wasn’t even a mainline Sonic title to headline the system. Several Sonic games were released, like Sonic Jam, Sonic R, and a port of Sonic 3D Blast, but nothing had the same pull that the Genesis classics did.

Given the importance of the Sonic IP during the Genesis days, it might come off as strange that there was no new flagship title for Sega’s next-gen console. This was, in fact, due to the cancellation of Sonic X-Treme, which would have not only fulfilled that role, but also been the hedgehog’s first foray into true 3D. As with the development of the Sega CD, 32X and the Sega Saturn itself, Sonic X-Treme was always plagued by conflicts between Sega of Japan and Sega of America.

After the success of Sonic the Hedgehog on the Genesis, a US-based team called Sega Technical Institute was established by Mark Cerny, who you may know as the lead architect of the PS4 and PS5, to work on its sequels. Following the completion of Sonic & Knuckles, Sonic co-creator Yuji Naka would return to Japan to begin work on Nights into Dreams for the Sega Saturn.

The western development team, meanwhile, were left to continue supporting the Genesis during its twilight years, and elected to do so with another Sonic platformer. Though its premise had gone through multiple iterations, Sega of Japan ultimately ordered them to move to the 32X, and then move again to the Saturn after the ill-fated add-on was abandoned.

The less than stellar relationship between the two branches, however, meant that Sega of America initially had no development kits to work with, and would only receive a single kit later on. STI had a tall order ahead of them, along with getting past that truly unfortunate acronym — with development having begun in 1994, they had to deliver the final product in late 1996, in time to tie in with a planned live-action Sonic movie at the time. The team barely had any experience with 3D games, and this was to be their first foray into 32-bit development.

STI split X-Treme’s development team into two: one would handle the boss fights, and the other would handle the game’s many stages. This second team would do so using tools on Windows PCs, as the only other option would have been to share the single dev kit, slowing down progress even further. In order to port this PC-created work back onto the Saturn, development was eventually outsourced to Point of View Software.

Internal politics would begin to rear their ugly head at this time, leading executive producer Michael Kosaka to resign. To make matters worse, Sega of Japan would later send executives in early 1996 to check on X-Treme’s progress. Unimpressed with what the level design team had created, Sega of Japan ordered the team to scrap everything and rework the game using only the boss fight engine and its mechanics.

Around this time, Sega of America vice president Bernie Stolar approached the team. Knowing how badly things were going, he offered to help however he could in order to get the game done by its deadline. Producer Mike Wallis suggested that getting their hands on the engine and tools used by Sonic Team for Nights would be “a godsend”. Yet only two weeks after the team had their hands on these tools, Yuji Naka himself demanded that they cease using them, or else he’d quit the company entirely.

By mid-to-late 1996, morale was at an all-time low after a messy, incohesive period of development fraught with inter-branch disputes, as well as the struggles of the Nomad, yet another piece of Sega hardware, with this one being a portable version of the Genesis that never quite caught on. Programmer Christina Coffin and designer Chris Senn would both fall severely ill, with Senn in particular having been told he had six months to live. Though Senn would eventually recover, the setback at this stage was simply too much, and recognizing that it was impossible to meet deadlines at this point, Sega finally canceled Sonic X-Treme.

The Saturn’s entire lifespan, from conception to release, including its games, was symptomatic of Sega’s lack of a clear and cohesive vision, both internally and publicly. The decision to release the 32X to squeeze more sales and life out of the Genesis in the west before following up with the Saturn next year threw everyone involved into disarray; third-party developers were confused on where to focus their development resources (with many deciding to simply jump ship to the PS1), gamers who were burnt by the Sega CD and 32X balked at the idea of having to buy yet another console, and Sega themselves could neither fully focus on the Saturn nor prolong the Genesis’s potency as much as they’d intended.

Though the Saturn did ultimately see its share of classics and all-time greats, the many factors working against it meant that it sold a dismal 9.26 million units — a drop in the bucket compared to 102.49 million units sold for the PlayStation.

In light of Sega of America’s continued failures and mounting frustration over being overruled by Sega of Japan’s poor decisions, Tom Kalinske left the company on September 30, 1996, replaced by Shoichiro Irimajri.

 

Dream’s End

The empire that Sega had built with Sonic and the Genesis had already begun to crumble; for their next system, they needed to knock it out of the park. But as with the Sega CD, 32X, and Sega Saturn, the Dreamcast met with trouble before it even released — an ominous sign for what was supposed to be the company’s big comeback.

This time, two separate teams were established around 1997 to design the system’s hardware. An internal team at Sega of Japan opted to use the Hitachi SH4 CPU and VideoLogic’s Power VR2 GPU. A secret team in the US initially opted for the IBM/Motorola PowerPC 603e before being told to switch over to Hitachi.

Remember how Sega of Japan wanted control on the western branches in the hopes of preventing leaks? History would repeat itself here, this time with even more serious consequences. The US based team entered a contract with 3Dfx to use their graphics technology which was incredibly promising — too promising, in fact. In 1997, 3Dfx went public due to their successful graphics cards, and by US law, had to reveal details of their contract with Sega, including the then-unannounced new console.

Sega of Japan was absolutely furious at these revelations — so much so that they severed ties with 3Dfx and went with the PowerVR2. 3Dfx, for their part, retaliated with a lawsuit claiming a breach of contract, and both companies would settle out of court.

Sega’s decision to use Japanese hardware had another unintended effect. EA had invested in 3Dfx, having seen its potential, and Sega’s partnership with companies that were unknown by comparison baffled EA. They would have still been willing to support the Dreamcast had Sega picked even a direct competitor to 3Dfx, but ultimately shunned the console due to Sega’s decisions. Given how much EA supported Sega’s past systems, this was already a huge blow to the Dreamcast’s potential library.

It wasn’t all bad, however. After a stint as executive vice president and founding member of Sony Computer Entertainment America, Bernie Stolar joined Sega to help push the Dreamcast. With his help, Sega took Visual Concepts under their wing, and put them to work on what would become the 2K sports franchise — games that would be influential and pose enough of a threat to EA that even years after the Dreamcast’s demise, they saw fit to sign an exclusivity deal with the NFL to quash all other potential licensed football games except their own Madden NFL.

The Dreamcast’s early days were promising; the launch lineup was strong, consisting of titles like Soulcalibur, Power Stone, and Sonic Adventure. The system itself seemed primed to stand against the competition: four controller ports to match the Nintendo 64, higher capacity disks compared to the PlayStation, and internet connectivity to set the Dreamcast apart. Sega’s latest and last console managed to hit $132 million in sales at launch.

The reality, however, was that the Dreamcast was still being sold at a loss, and despite needing to sell a lot of games extremely quickly to recoup costs, Sega chose to continue recklessly spending more money than they could afford, including sinking anywhere between $50 to $70 million on the development of Yu Suzuki’s Shenmue.

Shenmue, which began life as a Virtua Fighter RPG for the Sega Saturn, ultimately became one of the Dreamcast’s premier action-adventure titles, selling 1.18 million. It was released to widespread acclaim, and is considered a pioneer in urban open-world games — a pioneer that also popularized game mechanics like quick-time events.

Shenmue may have been acclaimed and beloved among its players, but it came at a hefty price. The aforementioned development and marketing costs — though a bit quaint by today’s standards — was absolutely massive in its time, and would have required an absolutely impossible amount of sales to recoup. The game was ultimately a commercial flop, one that sadly helped push along its console’s demise.

Though the Dreamcast had an incredible start, Sony still dominated 60% of the market by the end of 1999. The Dreamcast — which launched on September 9, 1999 — saw sales begin to dip by the start of the following year.

In the face of the impending western PS2 launch in late 2000, Sega of America president Peter Moore (who had been promoted earlier that year from his position as senior vice president of marketing) began pushing the Dreamcast’s online capabilities with SegaNet, adopting an extremely aggressive pricing strategy that not only saw the system’s price slashed down to $149, but full rebates for those who purchased an 18-month subscription for the online service.

This predictably only made Sega’s financial woes even worse, and failed to achieve the desired results. A remodeled PS1 system was the best selling console in the US during the 2000 holiday season, and while the PS2 was held back by shortages, consumers at this point were willing to wait for the highly anticipated system instead of buying the Dreamcast.

The years of financial deficit at Sega had consequences internally. In order to take responsibility for the company’s failings, Sega president Shoichiro Irimajiri would resign, and CSK and Sega chairman Isao Okawa would take his place in early 2000.

By September 2000, Moore saw the writing on the wall. At a business meeting, he and fellow Sega executive Charles Bellfield told Sega of Japan’s executives and development studios that Sega needed to get out of the console business — a statement that shocked them to their core, prompting them to simply leave the room.

Sega ultimately still had to face reality, however, and on January 31, 2001, the company announced that effective at the end of March that year, they would be discontinuing the Dreamcast and transitioning to third party development.

This alone wouldn’t have been enough to save the company; Sega had been in such dire financial straits after a long string of failures and financial losses that they were at risk of bankruptcy.

Isao Okawa, who together with CSK had loaned Sega $820 million to fund the Dreamcast, would intervene with a stunning act of generosity in his final months. On his deathbed, he would waive this debt and go even further by relinquishing his shares of Sega and CSK to Sega, totaling $695 million.

Okawa’s generosity single handedly eased Sega’s transition to third-party publishing, and in March, Sega and Microsoft entered a deal to publish 11 titles on Xbox. The blue blur himself would likewise make his debut on Nintendo systems with Sonic Advance in December 2001 for Japanese gamers, with an American release following just a few months later.

Sega was no longer the bold and brash console maker that built its success on directly challenging an industry titan, but Okawa’s injection of capital allowed them to remain in the industry as the stalwart publisher they’re known as today. Though the company and its divisions are still prone to making poor decisions from time to time, its most beloved properties, such as Sonic, Like a Dragon, and Persona (under the Atlus umbrella) now regularly reach millions of gamers around the world on a variety of different platforms. The Dreamcast was dead, but Sega had survived, free to chase new dreams.

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