Transcript: (disclaimer: may contain unintentionally confusing, inaccurate and/or amusing transcription errors)

Ben: Welcome to season 12 episode 3 of Acquired, the podcast about great technology companies and the stories and playbooks behind them. I'm Ben Gilbert.

David: I'm David Rosenthal.

Ben: And we are your hosts. Video games are an absolutely enormous industry with a market size of over $100 billion of consumer spend every year. That makes it bigger than Hollywood and the music industry combined today in 2023. While we are all aware that games are a fixture of life today from your kids playing Minecraft on an Xbox to you popping open Candy Crush on your phone for a flight, this phenomenon of humans spending all this time playing video games is actually pretty new.

Once upon a time, video games were a tiny niche market aimed at just teenage boys as a subset of the toys category that had fits and starts. It was not all up into the right. In the early 1980s, the video game industry in the US had some dire straits and nearly evaporated entirely, until Nintendo made a huge bet and changed history forever.

David: I've been a gamer all my life. I love video game history. I was so looking forward to doing this episode and covering Nintendo. I had no idea what an incredible story it is of how Nintendo single-handedly resuscitated this industry, achieved 95% global market share, and dominated this multibillion-dollar industry that was left for dead. That is the story we're going to tell today. We're not going to get to the Switch. We're not going to get to the Wii. We're barely even going to get to the Super Nintendo.

Ben: In this episode, we'll be covering Nintendo's early years or at least the first 100 years of the company up until about 1990. I think we have a part two in the works because the story of Nintendo after 1990 is a completely different company and a completely different set of analyses to do so. Consider this a part one and truly a story all to its own.

Listeners, we have a big announcement. We are renaming the LP Show. The LP Show has been public for the last year and has effectively served as Acquired's ESPN2 channel. We're going to make it official. The LP Show is now known as ACQ2. It still has the same great expert interviews with founders and investors like Vijaye Raji, the former Facebook exec who founded Statsig, and Meghan Reynolds, the head of capital formation at Altimeter.

You can still find it in every single podcast player whether you’re an LP or not. if you've never given it a shot, there is no better time. Just search ACQ2 in any podcast player. We have some banger episodes coming up in the next couple of months on the calendar. For our LPs, just so you're not confused, we will keep updating your old feed with all these new episodes just so you don't miss them.

Speaking of the LP program, we are revamping it. It is not going away. We want to basically shift away from it being about these episodes and make it more about bringing you closer into the Acquired kitchen. For our limited partners, we're bringing back private Zoom calls that we'll email you about the next one soon, and we'll be adding a new feature. You can help us pick future episodes. LPs, look out for an email on that and more stuff to come. You can join at acquired.fm/lp.

After you finish this episode, come discuss it with the other 14,000 smart, thoughtful, kind, curious members of the Acquired community at acquired.fm/slack. Without further ado, David take us in. Listeners, this is not investment advice. David and I may have investments or make investments soon in the companies that we discuss, and this show is for informational and entertainment purposes only.

David: There are quite a lot of books written about the history of Nintendo, some of which are very good, and we've read basically all of them at this point. In particular, I would highly recommend Game Over and Power Up.

Ben: Yup, and I read Super Mario. Also great.

David: The thing that we realized and Ben and I were texting about this as we were doing the research, all these books either focus on the Nintendo Japan story or the Nintendo America story, or the video games in America story or the video games in Japan story, and they keep them separate. It's super weird to us. I think that misses the point of the story here, which is that the rise of video games and the rise of Nintendo is this incredible inner-woven global tale. Nintendo of America wouldn't have happened without Nintendo of Japan, and Nintendo of Japan would not at all be what it is without Nintendo of America.

What we're going to try to do here is unite these stories and tell them together as one canonical Nintendo story, I think maybe for the first time. I don't know, at least that we found. This is going to be fun. Speaking of this, we start our story, appropriately enough, not in Japan in the late 1800s when Nintendo was founded, but in California in the 1970s with a friend of the show and one of, if not maybe, the original father of Silicon Valley, Nolan Bushnell of Atari.

Ben: And certainly the father of the video games industry.

David: We had a chance to interview Nolan back in 2019 on the show. You can find that episode in our back catalog. He is such a character. You can't understand him without listening to him. He is one of a kind.

Nolan grows up in Utah, of all places, in the 1950s. He's just from birth this incredible hustler and entrepreneur. One of the jobs that he gets growing up is working at carnivals. He's literally a carny. He keeps referring to himself as a carny in our interview with him, which is fun.

Arcade games back then in the 50s and 60s were not what we think of arcade games today. They were what's called electromechanical games. These are things like everything from you shoot the water gun to make the balloons pop, to little lights and stuff going on, you swing the hammer to hit the bell.

They were games and they might have involved some circuitry components, lights and sounds, but they were not video games. Lots of bars had games like this, they were something to do at bars. In fact, one of the leading companies that made these electromechanical games back in the day was a company called Sega, which will come up later.

Nolan, in addition to having this incredible entrepreneurial streak and background in arcades, does something pretty unique. He goes to college at the University of Utah and majors in electrical engineering. This was a pretty special place in the department to be in at that time. Other folks who came out of the University of Utah engineering school around this time, Alan Kay, Jim Clark of Silicon Graphics and Netscape, Ed Catmull of Pixar...

Ben: All of which have been protagonists of Acquired episodes.

David: I know. It's just incredible Silicon Valley DNA that comes out of that time, and specifically focused on graphics and innovating there, which of course, Nolan becomes part of this tradition. While he's there, he programs on a DEC PDP-1. This is one of the original old school computers from the 50s and 60s. They, MIT, and several others had one of these devices. Folks at MIT had, in their spare time, created a game for it, the very first video game played on a programmable computer, which was called Spacewar! It was a very, very early rudimentary of asteroids, but not quite space invaders.

Ben: Or Galaga. It's funny how many early video games were space games because of Spacewar! They were inspired by and derivatives of Spacewar!

David: Of course, what's a really easy graphical game that you could put on a black screen, that you had green little lines that you can manipulate on? Space, there's a lot of black in space.

When Nolan sees this, he's like, whoa, holy crap, nobody else who was playing Spacewar! in the entire world or using a PDP-1 has also worked at carnival arcades. Nolan's like, man, this would kill it if I could bring it back to the arcades.

Of course, at the time, I think a DEC PDP-1 cost over $100,000, which is over a million dollars today. The idea that you could domesticate this animal, not even bring it into homes, but get the price point down to a point where bars, arcades, or carnivals could afford to buy these things is like no way.

Ben: Totally. It just literally never pays back when you're thinking about, I don't know if it was nickels or quarters, but whatever you're putting in the arcade machines. It's just never going to pencil.

David: When Nolan graduates, he comes out to Proto Silicon Valley, and he gets a job as an engineer at one of the leading companies there at the time, a company called Ampex. Their main market was making tape recorders that were used for movies, television, music, recording industries. But all the time that Nolan's working there, he can't really get both his entrepreneurial, carnival master DNA, and this idea out of his head of, if you could domesticate video games and bring them to the consumer market, they would do really well.

Finally, after a couple of years, by 1969, he thinks, thanks to Fairchild, National Semiconductor, and now Intel at this point, silicon has gotten cheap enough that maybe you could do this, basically take Spacewar!, and build a machine cheap enough that you can sell it into arcades and carnivals.

Ben: It's a total Moore's Law story. It's exactly the way that we opened our NVIDIA episode with. Maybe not yet, but I can see it in the next year that it'll get cheap enough to make this new business viable.

David: Yup. He packs up and leaves Ampex, goes to start a company with fellow Ampex employee Ted Dabney, and their business plan is they're going to do exactly this. They initially call the company Syzygy, but it turns out that name is already taken by a candlemaker in Mendocino, I think Bill had told us.

Ben: I was going to say, the problem with that name is that it's terrible, not that someone else also decided it was a good name.

David: Thank God it was terrible. Nolan racks his brain and comes up with an alternative idea. He's become a big Go player, and he takes the term Atari from the game of Go, which Atari basically means the equivalent of check in chess in Go. They build a game called Computer Space that's based on Spacewar! This is the first commercialized, programmed video arcade game in history. They put it together, they contract with an arcade distribution firm called Nutting Associates to distribute it.

It's okay. It's not really a profitable enterprise yet because the amount of silicon required to run the game—remember, this is coming from cutting edge scientific military use computers—is still enough that it costs too much to make these machines. It's not really economically viable yet. It has another more important problem, though, which is that consumers in America aren't really ready for space games. They haven't yet made the leap to, we're going to live in fantasy worlds, and we could pretend we're piloting a spaceship out in space and blasting enemies. That doesn't compete yet with audiences.

Ben: Right, it's escapism at its finest. Now we take it for granted that whenever you play a video game, you're entering some escapist fantasy, but that was a brand new novel idea.

David: They get this feedback, Nolan and Ted. They think, all right, we need to make this technology simpler so that it's more affordable and cost-effective. They hire one of their co-workers from Ampex, a guy named Al Alcorn, who's an amazing engineer. One of the themes that's going to come up a bunch in this episode is the mythical 10X, 100X engineer game designer, somebody who can do things that other people can't.

Specifically, what was really valued in Silicon Valley and Technology Engineering at this time, was the ability to design systems with the highest amount of functionality with the fewest number of chips, because every chip that you put in there, added a whole lot of cost to the bill of materials.

Ben: Not just on the raw costs, but on the assembly time. Soldering takes time. At this point, there's very little software involved in these games. You're mostly hard coding the functionality onto the motherboard itself, depending on what chips you put in.

David: To put a finer point on that, I don't think there's any software involved. I think everything is hard-coded in these chips at this point in time.

Ben: This is managing to create games using just electrical engineering.

David: Something I hadn't even thought about till now, all of the applications of silicon to this point in time, were mostly for military use cases. Some went for industrial and commercial use cases, but the end products, the physical devices that were being produced by all these companies, were not meant to be distributed in large numbers to consumers. If you're making systems for the government, you're not making a high number of machines.

Ben: We were in the like hundreds, maybe low thousands of devices when you're considering military communications equipment. Now with arcades, you're into the thousands and potentially tens of thousands, which is a huge leap.

David: All this value engineering, you can see why it's super, super important. So, a huge win. They bring Al Alcorn over. He is the engineer that can make this happen. To get him started, Nolan decides that he's going to give Al—because Al has never made a game before—a training project to get started. He is thinking about, what small toy game could I give out? It just so happens that Nolan had recently been to a demonstration by the consumer electronics company, Magnavox.

Magnavox, at this point in time, was one of the companies riding the wave of televisions across America, as we talked about it in the NFL and plenty of other episodes. They were looking for ways to market their televisions as superior to other manufacturers out there like RCA or what have you. They had come up with this little device that plugged into their televisions called the Odyssey. They called this thing a closed circuit electronic playground. What it actually was was the very first home video game console. They just didn't think about it that way.

Ben: This just goes to show too, a lot of the times before a category is created, you don't know how to describe the job to be done of the very first product in the category. You come up with some really esoteric name like that. It's only when five other competitors come in after you does the category get a name like video game consoles or home video games.

I think this came up way back when we interviewed Vlad from Webflow on one of the earliest Acquired LP now ACQ2 episodes. He brought up the fact that he's like, oh, people started calling us no-code. He was like, we've been going for five years. We had no idea we were a no-code company, but now, apparently that's a thing. That's exactly what happened with the Magnavox Odyssey.

David: It's even more extreme than that. Not only did they not know what to call it, they had no idea what this market was. They thought this thing was a gee whiz device that they could have their sales reps in their stores around the country demonstrate to consumers to help them sell TVs. That's all that they thought about. They didn't think that this would be a market or a product line in and of itself.

They had created this machine in partnership with a guy named Ralph Baer, who really created it. They licensed it from him, and he's known as the father of home video games. They had game cards that you would plug into the Odyssey. Depending on which game cards you have plugged in, you can play different games. We'll see as we go along here, but it wouldn't be for several more years until that idea would come back. And people would realize, oh, hey, there's actually a value to selling not dedicated hardware into the home of this console that only plays this game, but you want an interchangeable software here.

This Odyssey, like we said, Magnavox has no idea what they're doing with it here. You can't blame them, there's no roadmap for this. But in what should have been assigned to them and certainly was assigned to Nolan, even though they were not marketing this as a standalone device or anything like that, it becomes a pretty big success anyway, despite Magnavox. They ended up selling a couple of 100,000 units of this thing.

Ben: The Magnavox Odyssey was invented to solve a problem that Magnavox had. What they failed to realize is that it had a tremendous job to be done for consumers, where they accidentally fell backwards into a goldmine, but did not feel around enough to grab the gold.

David: Nolan, though, when he sees a demonstration of this, probably the most compelling game on the Odyssey was called Table Tennis. It was like a very, very rudimentary approximation of either tennis or ping pong (table tennis), that you could play with the Odyssey on your computer. He brings this back to Atari and to Al and says, make something like this as your test project here. Al, of course, does it brilliantly. They start playing around with it at the office and they're like, dang, this thing's  fun.

Ben: Wasn't it like a proof of concept game? It was basically a demo to show off the potential of what they could do as Atari. They didn't realize, in creating Pong, right there on the spot, they invented a mega hit as the proof of concept.

David: Yes, that was the thing. Famously, they take the first cabinet to Andy Capp's Tavern in Sunnyvale, California. They convinced the owner there to set up this Pong machine (as they start calling it) at Andy Capp's, and it just becomes a quarter vacuum, like a magnet. Literally, all of the pieces of coin in customers' pockets just get sucked right into Pong. It's incredibly compelling.

The thing that makes it so accessible to just average people who are going to the bar is it's relatable. You don't have to make the leap that you're a pilot of a spaceship out in space. Everybody knows what Table Tennis is. You know how to play this game, you know what you're doing, and that gets you in to try it.

Once you start playing this thing and you get engrossed in it—and Pong at this point in time is only two player, there's no AI here, you have to play against somebody else—you get the competitive factor going, especially in a bar, and they're like, oh, we got something good here.

They start producing these cabinets, selling them to bars and arcades around the country. It's going really well, so well that a certain newly minted venture capitalist comes and seeks out Nolan and Atari, the legendary Don Valentine.

Ben: When you say newly minted, it's funny in today's terms. He'd be like an emerging manager. I think he had raised a $5 million fund. This is effectively like Sequoia Fund I looking to make its first investment.

David: Yes. Atari become Sequoia Capital's very first investment. It goes even deeper than that. With the money. Nolan and the team at Atari start bringing on additional folks to build and engineer games that they can sell. This Pong thing worked out pretty well. They hire a young kid named Steve Jobs to come in and design a one player, a solo version of Pong that you can play, which ends up being called Breakout that he does with his buddy, Steve Wozniak.

Ben: This is my favorite hidden Atari story, is that freaking Steve Jobs was the designer and the creator with Steve Wozniak of Breakout.

David: Just like that, not one, not two, but three industries are born. You've got the home video game console business with Magnavox and the Odyssey that Atari copied with Pong, you've got the arcade video game business that Atari is really entering here, it starts to take off faster than anything, and then you've got the personal home computer business that Steve and Woz started with Apple. It all comes out of this one moment, which is incredible.

Unlike today with games or any type of software, there is no app store out there. It turns out that distribution is a critical element to building a technology company. The arcade business with Atari starts to really take off. Both existing electromechanical games companies like Sega and others get into the video game business. Atari is out there, obviously the leader.

By the mid- to late-70s, the top arcade games out there were making billions of dollars in annual revenue, like Space Invaders, which was launched by the Japanese company Taito in 1978. It does $2 billion in annual revenue in the US alone.

Ben: What year is this?

David: This is in 1978.

Ben: I don't think I realized how big the arcade market got before there were even video game consoles in the home. I've done all this research and I did not realize how big the arcade market was.

David: This industry, not only did it dwarf the home console industry that the Odyssey started. It dwarfed the personal computer industry. This was the main application of silicon for the 1970s for consumer markets. By the end of the 70s, the total video game arcade market is $5 billion a year, which is already by then—you said in the intro, today, video games are bigger than movies and music—it was already bigger than movies and music by the end of the 70s.

Ben: That's a sudden narrative violation. I thought this notion of eclipsing Hollywood in music was a recent phenomenon to show how much time people spend in games. What you're pointing out is that it was a different form factor and it was a physical location at arcades, but that's basically always been true.

David: It was this ultimate hack to get distribution of this new technology and business into the mass consumer market. People already went to bars and arcades. This was a better product of what they already did. The industry just took off like wildfire.

Ben: The fascinating thing about this pre-home console era is that there's basically no intellectual property yet because there are no stories yet. These video games are so basic with Pong, with Breakout. It feels silly to compare it to Hollywood because there are not real franchises, characters, stories, and anything you can repurpose. You're not going to figure out how to make Pong into a movie or a TV show. There's nothing there.

David: You could, but it would probably be pretty bad.

Ben: It's a false comparison at this point in history.

David: Yup. But again, it makes total sense. This came out of arcades, carnivals. You don't need a story here. This is about competition in a public environment. As Atari really starts to take off through the early- and mid-70s, Nolan decides that, hey, they should probably get into the home video game business, too.

Ben: Moore's Law keeps happening, we can now create what used to take a whole cabinet into a small box that you plug into your TV that's purchasable by a consumer, rather than costing tens or hundreds of thousands of dollars. It's finally happening.

David: They start working on a programmable machine that can play versions of popular arcade hits at the time. They codename it the VCS, the video computer system. As they start working on this, he and the board of Atari realize this is going to be a very different business with different dynamics than the arcade business.

The first and most visceral thing they realize is, this is very capital-intensive. It takes a lot of firepower to bring a home console to market in the right way. With arcade games, you make the game, you work with a distributor like Midway, Valley, or something like that, you get it into arcades and bars, and the money comes in. The cash flow cycle is very quick.

Ben: You make one of the machines and a thousand people can play it. The way to address a thousand consumers is to make a machine and let them flock to the bar to drop quarters in.

David: But in the consumer market, things are very different. You need to get machines into retail, and then you need to get retailers and marketers behind what you're doing and build demand amongst consumers for people that have a reason to go to the store, buy your thing, and bring it home.

Ben: You need to build a hundred, a thousand times more machines to address that same set of consumers in their home.

Ben: Toys R Us isn't going to buy your product for their stores if you only have 10 of them. They're going to buy your product if you have at least a million of them. Silicon Valley has not evolved to the point yet, where there are big growth funds out there that could come in and give Atari a couple of hundred million dollars to build up this inventory. They decided that the right thing to do is sell the company.

They end up selling it to Warner Brothers in 1976 for $28 million. This becomes one of the greatest acquisitions of all time for a very brief period. But during that brief period, the payback on Warner Brothers $28 million investment is pretty incredible.

Ben: That ubiquitous Atari 2600 system that everybody has a fond memory for and recognizes pretty instantly, basically all the value of that accrued to Warner Brothers, not the founders and investors in Atari, the independent company.

David: Yes. They acquired the company in 1976. In 1977, they release the VCS, which gets renamed the 2600. It's a smash hit. It sells a million units in the first year, and then sales double every single year for the next three years. It's so huge that by 1980, just three years after the 2600 launches, the Atari division of Warner Brothers does $415 million in revenue, which is 1/3 of all of the revenue that Warner Brothers does. Basically, Warner Brothers, the publicly-traded Hollywood studio becomes a video game company for a couple of years.

Ben: That's insane. I had no idea it was that meaningful to Warner.

David: This is the thing that has just gotten lost to history. The video game industry took off almost nothing we've ever even seen to this day.

Ben: We're building up to this impending crash here, but boy, those first five years were incredible.

David: It is a total gold rush, so much so that Atari is not the only one who's making money here. Lots of other toy companies, other media companies decide, hey, they want to get in on this home console video game business, too.

Mattel enters the market. A toy company called Coleco enters the market, which actually had its roots in the leather business. It's the Connecticut Leather Company. Everybody's coming into the market here.

Ben: It quickly became a subcategory of toys in the American consumer psyche. The way that people thought to spend on this is, oh, my 8-year old to 18-year-old son needs a toy. It's a big birthday or something, so I'm going to get him a really nice toy, which is going to be one of these video game things.

David: Specifically the magic to this and why these became so popular as toys, and what informs the whole business model for decades to come, is the swappable game cartridges. If you buy an Atari 2600, you're not just buying a toy for this year, this birthday, or this holiday. You're buying toys for the next several years to come.

Ben: This is a full lean-in on the Razorblades' Razors model, where I'm pretty sure Warner wasn't actually generating gross margin on the Atari 2600s they were selling. They would make all the money on the games, which has been true even in the modern gaming era. If you look at the incredible amount of firepower in the Playstations and Xboxes of the last 10 years, those things sell for the very cheapest they possibly can in order to get an install base so that they can make money on the games. That's what was happening with Atari here, too.

David: Totally. Everybody's figuring this out all at once, so much so that a few engineers at Atari, after the acquisition, start to realize this and they think, man, all the money, all the profits, are in the software here. What if we leave Atari and we set up a new company that's just going to make games? We're not going to make hardware. We're going to make games for the 2600. They actually don't set up a deal with Atari, these guys. They start publishing their own games. They make the cartridges, they sell them on the market themselves.

Ben: Because Atari didn't require you to do a deal with them.

David: Nobody was thinking about third-party developers yet. These guys who left knew how to do it because they were Atari employees. The company they start is a little company called Activision, which is now in the process of being acquired by Microsoft for just about $80 billion, just as a third-party publisher. Atari ends up suing this new Activision. They're like, hey, you can't do this. They're fighting it out in court.

Ben: By the way, the reason they named it Activision is so it comes before Atari in the phone book. I'm pretty sure, Accolade, there were a handful of “A” publishers at the time that all had the same idea.

David: While they're fighting it out in court, which is so funny, somebody must have taken a step back at some point and realize, hey, wait a minute, what are we fighting about? There is so much money to be made here. What if we, Activision, just pay you guys, Atari, a royalty fee for every cartridge that we sell? You get 10%, 20%, 30%, it doesn't even matter. We're all making so much money. Atari is like, oh, yeah, you mean you make the games, you sell them, and we just get money? Okay, cool.

Ben: We have to take no capital risk on you developing that game. We just make money only if it works. Got it. Got it. Yes, please.

David: Yes, please, indeed. Obviously, that works out very, very well for all involved.

Ben: For a time for Atari.

David: Yes, for a time.

Ben: You've got this rush of competition coming in for the video game consoles.

David: Yes. The problem was it worked too well. We got the parallels to Web3 and crypto here just all over this episode. There was so much money to be made. Everybody rushed in with a "game" here. People were just shoveling any  software that they could, both the first parties like Atari, Mattel, and third-parties like Activision. They were just trying to get games in the stores because people—parents—would buy them without knowing what they were. It didn't matter if they were crap, it was just a license to print money.

Ben: It wasn't just the games. Once people realized the power of this royalty model, they wanted to come out with systems, too. You had 15 different companies rushed to market in the US with consoles. Suddenly, these toy stores got flooded both with games and consoles. As you would imagine, there's intense concentration in the consoles that got selected. There's a real ecosystem effect and network effects that need to be developed for these things to work.

For a console to be successful, you need a bunch of people buying the console. Once you have a reason for people to develop for your thing, then suddenly, you actually get the good games, not all the shovelware crap that's hitting the shelves. You needed the market to suss out, hey, can we consolidate down to just a few game devices, a few consoles, because otherwise nobody knows what to buy, nobody knows what to develop for, it's just a big mess, and the whole thing's going to be a failure as a category?

David: The problem was, it was so overcrowded and so over funded. Just like things in recent history here in 2023, that didn't happen. Nobody could figure out what was the crap, there was just too much out there.

Ben: The laws of economic physics were broken. Instead of free market dynamics playing out, there was just tons of incentive to just go make more stuff and get it out there, even if it may or may not work.

David: Remember, I said by 1980, the arcade video game business was a $5 billion annual industry in the United States. By the end of 1982, just two years later, the whole video game business is a $3.2 billion industry, almost as big. Combined, you've got a $10 billion industry that just sprung up overnight. Incredible.

Ben: Just to paint where we're going here, that $3.2 billion video game market, that home video game console market in 1982, by 1985 would be worth $100 million, a reduction of 32X in the market size because the entire category just went away,

David: Just disappeared. To put that differently, a 97% drop in market size within two years. Everybody who came into this industry, the third party independent software, game developers, the hardware guys, Atari, Warner Brothers, Mattel, they just lose their shirts. Remember, this is still the 1980s. Software has real cogs to it. These are physical packaged goods. These are cartridges and systems with silicon and chips in them.

Ben: And supply chains and labor.

David: There are billions of dollars of inventory tied up in these companies in all these systems in games, that all of a sudden, now are sitting on shelves and can't sell. All these companies have huge losses. Publicly traded Warner Brothers company has to report massive losses, so much so that to appease Wall Street, they have to break up Atari and sell it off. They sell the console business and the games business separately. Coleco and Mattel completely exit the video game business. The whole industry, the home video game industry, is just decimated, it's dead. This is when the famous ET Atari game, the cartridge burial happens in New Mexico.

Ben: Atari made so many of these ET games that they jointly developed with Universal. In fact, Steven Spielberg himself was involved in approving the concept of yes, let's turn ET into a game. The game was so poorly made. The actual game mechanics were so not fun, much like basically every other game at the time because you're trying to figure out what console to make it for, you make it for five consoles, you're rushing to market with this and 16 other games at the same time. Eventually, the quality of every single thing that's hitting the market is so low because all the incentives were to just get crap out there that consumers just stopped buying.

Stores just stop buying upstream, specifically consoles. They stopped buying games, but they really stopped buying consoles, except for the one, two, or three that are the leading consoles. But even then, they're not placing big orders anymore. That's how you have this whole whip crack effect all the way back upstream to the game makers and the new found publishers, these third-party developers, that the whole thing collapses.

The interesting thing with ET is, to your point, they didn't want people discovering the buried games, then reselling them for cheap, and compounding the problem even worse. They literally took wrecking balls, they're smashing the cartridges, they bury them in a landfill, and they pour concrete on top. People have gone and excavated this and looked. This is a real thing that they had to bury all this inventory.

David: Point is it was brutal. Like you said, Ben, the way this industry went to market was this part of the toy industry. This is actually not anything new for the toy industry.

Ben: Toys are so cyclical.

David: They're fads. The mental model that everybody here in America has for what just happened is, ah, the home video game console was like the hula hoop. Specifically, you mentioned Coleco, which entered the industry. When they get out of the video game industry, the next thing they do is Cabbage Patch Kids dolls. This is just how the toy industry works. You move on to the next thing, you make as much money out of it as he can before the kids move on, and the generation changes.

Ben: It's fad-based and it's super seasonal. Basically Q3, Q4 matters and you're not selling anything Q3, Q1. It's like just the rush up to Christmas. Everyone's viewing it as, oh, 1982's Christmas toy was the video game console and, oh, yeah, it didn't really pan out that people would want those in more future years. But I'm sure we'll find something else.

David: Here's this opportunity of a lifetime, sitting right there in plain sight for anybody who has the foresight to actually realize this, which is the video game industry, specifically the home video game industry, is not like toys. There actually was incredible product market fit and demand for good games out there. There's a reason why kids wanted this stuff. The business model of a home video game system is one of the best of all time.

We talked on this show about how the software business model is the best business model of all time, and the media business model is the second best business model of all time. Video games are software that is media. It doesn't get any better than that. You sell a console or whatever. You lose money on the console, who cares? You sell games into homes across America and across the world at $50 a pop that even with all the manufacturing costs, you still make an 80% gross margin on this stuff. That's pretty incredible. You can sell 3, 4, 5, or 10 of them a year.

Ben: Especially once you flash way forward to games today. There are zero marginal costs to make another copy of the game. There are zero distribution costs because you just ship bits over the Internet. And to your point on top, it's media that is software. It's also IP.

We're about to tell the Nintendo story here as we transition to Nintendo and how they really find story and characters in an industry that just had non-human characters, spaceships, and inanimate objects. You have a whole new level on top, which is the durability of IP franchises that is about to come into view for the first time.

You're right. Unbelievable business model to produce these games. If you can be the platform maker and get all of the platform network effects that accrue when you are the game console manufacturer, God, you put those two things together, that is a pretty great combo.

David: Enter Nintendo.

Ben: David, this is a great time to thank one of our very favorite companies, the first of this episode, pilot.com. We mentioned we are doing something different this season. As you know, Pilot is already the largest startup-focused accounting firm in America with over 1700 clients. They've scaled with companies that have grown 50X since becoming a customer of Pilot. We thought, okay, what can we do this season that would be helpful to listeners? Waseemm Daher, the CEO of Pilot, had a great idea. We are going to flash over to him to join us for this episode's tip that he has for founders after starting three companies.

David: Today, Waseem, we're going to talk about your views on competition.

Waseem: Here's the thing about competitors. You're going to spend all of your time agonizing over who they are, exactly what they do, and what changes they made on their website. Unfortunately, that is all time that's basically wasted. Your competitors are, for the most part, completely irrelevant. Anytime you spend thinking about them as time you're wasting, it's time you're not focusing on what actually matters, which is building a product that's good, that your customers love, and that they're willing to pay you for.

The reality is your actual competition is not firm XYZ, it's actually the status quo. Supposedly, Visa's biggest competition is not Amex, its cash. That's true with your company as well. The biggest competition is probably not the person who has a company that's like yours, it's probably people not adopting your thing at all.

Ben: If this were a podcast about incumbents and how to be a great incumbent versus other incumbents, then we could talk about getting baked off when you're a completely mature product versus someone else's completely mature product. But if you're listening to this, you're probably building something new and interesting in a category that is still being established.

Waseem: Absolutely. The other thing that's true is that it is rare for markets to truly be the winner-take-all. Even if your competition exists, it's not like 100% of the market is going to go to them or 100% of the market is going to go to you. Two data points I think are really instructive here. Salesforce has something like 21% market share and CRM. Salesforce is the obvious juggernaut in the space in only a 21% market share. Then Amazon, AWS, it's 33% market share.

Even if there's a dominant provider in your space, as long as the market is big, there’s still lots of room for you to grow. That's especially true if your perceived competition is a new startup because they're not going to be a juggernaut in the space. They're going to have 0.0002% of the market, and you might have 0.0001% of the market. That's really the dynamic we're talking about here.

By the way, this is a mistake that even seasoned entrepreneurs make. I wish I could tell you that at Pilot, I'm blissfully unaware of what our competition is doing. Obviously, I'm looking at their website and stuff. The way that you're actually going to win is by focusing on actually making the customer experience good.

Ben: Out thanks to Pilot. You can click the link in the show notes or go to pilot.com/acquired and get 20% on finance, accounting, and tax prep needs for your first six months. Our thank you to Pilot.

David: Thank you, Pilot.

Ben: Okay, David, as we get into the Nintendo story here, there is one thing I think that's important for listeners to know before we flashback and tell Nintendo from day one, which is that the US video game market is decimated. But in Japan, for home game consoles that were just starting to really find their footing around 1983, they resisted the urge to import all of these American consoles that were flying off shelves.

In Japan, you had a completely different dynamic, which was there were only a few consoles, but they were selling quite well, and they didn't have a ton of competition. There actually was a moment in the Japanese market to look around and observe, when we make high quality games, people totally want to buy them and pay for them, and knowing that might give us an advantage in entering other markets, too.

David: Totally. We go back to 1889, 100 years earlier. In Kyoto, Japan, when one Fusajiro Yamauchi, who was the head of a cement company at the time in Kyoto, Yamauchi was actually not his original family name, he had become the head of the cement company because he had worked in it. The person who ran and owned the cement company was ready to retire. He didn't have any male heirs to take over the company, which is how companies transitioned in Japan.

What you did in that case was you adopted a male heir to take over the company. Fusajiro was actually born Fusajiro Fukui, but he took on the Yamaguchi family name to inherit this cement company. Similar to Nolan, many, many years later in America, Fusajiro was looking around for interesting new technologies and how we might apply it to a market that he knew had universal appeal, which was playing games, and specifically playing games for money.

He saw that there was an opportunity to get out of the boring cement business, and enter the playing card business. He sets up a new company. He names it Nintendo. The name of Nintendo is actually a multiple entendre. The kanji characters, Nin, Ten, and Do, can be interpreted as leave luck to heaven, which of course, references luck in playing cards, maybe the entrepreneurial spirit of a new venture.

Ben: But definitely plays on the fact that they're a gambling company.

David: That's what I was going to say. Specifically, the character Ten at the time was a clear reference to the mythical spirit, Tengu, which was a coded reference for gambling and casinos, which were very, very, very much still illegal at the time. Why did Fusajiro see the opportunity here? Playing cards and card games had originally entered Japan from the West in the 1500s, but then they'd been banned for hundreds of years when Japan's rulers followed a strict isolationist policy and basically kicked all Western influence out of the country.

I think I knew this, but I'd forgotten till doing the research. You know how they did that, the rulers of Japan for this multiple 100-year period from the 1500s to the 1800s?

Ben: No.

David: They institute the death penalty for any foreigners who enter Japan and any Japanese who leave the country. They meant it, all Western influence out of Japan. This goes on for hundreds of years.

Ben: Wait, if you entered the country, it was just so illegal that they would kill you?

David: Yes.

Ben: Oh, my God. I feel like I missed this part of world history.

David: Yup, but human nature is human nature. Even despite this very strict effort to eliminate Western influence from Japanese society, the allure of playing games and gambling for money is too strong to resist. During that time, the playing card system developed a substitute parallel track in Japan called, instead of the Western Deck, the Hanafuda cards. Instead of four suits, these cards had four seasons. Instead of 13 numbers and faces on the cards, they had 12 months of the year, but used for basically the same purpose, which is games of gambling.

By the late 1880s, after the Meiji Restoration, the government had finally removed the official ban on playing cards. Hanafuda cards existed for hundreds of years, but even they were underground. Finally, now you could legally produce these things. That's why Yamauchi starts Nintendo.

Nintendo becomes quite successful in this new industry. So successful in fact that they become the largest playing card manufacturer in Japan. You think, cool, that's great, interesting business, playing cards, fun games. I can see maybe how that leads to what Nintendo becomes. If you think about it a little more, though, playing cards are now legal in Japan, gambling is not, though. What is the main use of playing cards? It's gambling. Who are the primary customers for playing cards? It's not households.

Ben: Okay, anybody who's operating an illegal casino, basically.

David: It's organized crime. It's the Yakuza in Japan, the Japanese mafia.

Ben: I had heard whispers that there was some Yakuza involvement in Nintendo's history, but I didn't find anything about it. What do you got?

David: The Yakuza operated gambling parlors and casinos all throughout the country. There, just like casinos in America, when they play games with cards, they use a fresh pack of cards for every game because you don't want to have cheating. This is an incredible business. What an incredible customer for Nintendo. These gaming parlays run by the Yakuza, who need thousands and thousands of packs of cards, a very, very successful business and quite an interesting distribution capability that Nintendo builds up over these 50-plus years that they're just a playing cards company.

Ben: Wow. On this show, we talk a lot about value chain, where power accrues in the value chain, and how you get power as a company. It doesn't feel like you want your biggest customer to be the Yakuza. It doesn't feel like you want them controlling your destiny.

David: Maybe and maybe not. If you can navigate that successfully, you can really develop quite a lot of power within a market.

Ben: It's so interesting because in the US, the early arcade games industry was the same way. It was also a mafia thing.

David: We talked about this with Nolan. That is 100% the roots of Nintendo. Fusajiro Yamauchi runs this business for a number of decades quite successfully. He ends up having the same problem that his adopted father, the original cement entrepreneur, had before him, which is when it comes time for him to retire, he doesn't have a male heir.

He arranges for his daughter to marry a promising local young man named Sekiryo Kaneda. Sekiryo also changes his name to Yamauchi. He becomes, at this point now, the third coming of the mythical Yamauchi and the second president of actual Nintendo itself. Sekiryo also doesn't have any male heirs. For the third time, the Yamaguchi patriarch arranges to adopt an heir to run the business in the future.

Specifically, Sekiryo arranges for his eldest daughter, Kimi, to marry another promising young local man, Shikanojo Inaba. Shikanojo also adopts the Yamauchi name. He starts being groomed to take over the business. Finally in 1927, he and Kimi have a son, the first Yamauchi son in three generations. They name him Hiroshi Yamauchi. Unfortunately, here's where things start to go pretty terribly wrong for Nintendo.

Ben: What year are we in?

David: We're in 1932. This is before the war. Hiroshi is five years old. Shikanoko walks out on the family and abandons the business, the family, son, and leaves. Nobody knows exactly why. This is lost to history. But I got to imagine between all the pressure, the family, the business, the Yakuza connections, there's a lot going on here.

His mother, Kimi, also never recovers from this incident. She basically also leaves the family. Hiroshi Yamauchi, the first actual Yamauchi born in generations, is pretty much orphaned at this point. His grandparents, Sekiryo and his wife adopt him, but they're not parenting him, not to mention that World War II happens when he is an early teenager. The life that he grows up in is quite, quite, quite difficult.

Finally, when he's 18, the war is over. He makes what I assume must have maybe been a deal with his family and his grandfather. He escapes Kyoto and goes to Tokyo to study law at Waseda University. But in exchange for being able to do that, the family and his grandfather arrange a marriage for him as well to the daughter of a formerly high ranking samurai family. Pretty much right after this happens, a couple of years later in 1948, Sekiryo suddenly has a massive stroke and is completely incapacitated.

Ben: This is Hiroshi's grandfather.

David: This is Hiroshi, his grandfather, and can no longer run the business. He summons Hiroshi back from Tokyo from law school to Kyoto and commands him to take over the family business to become the next Yamauchi running Nintendo.

Ben: Wow. This is pretty young to take over the family business.

David: He's 21 years old. Because his father had walked out on him and the family, there was this missing generation here. His grandfather, who has this very complicated relationship with, has this sudden stroke. All of a sudden, Hiroshi has to come back and take over the business.

Ben: Listeners, the crazy thing is, you might be thinking, wow, so this guy probably has no idea how to run this business, it's unlikely that it would be successful. Interestingly, he develops into a leader who has an unbelievable eye, this killer taste, going to flash way forward like what games are fun and what games are not fun by not even playing them, like observing them for a half hour, and he's like, this is going to be a winner. It's amazing that out of basically no training and no real apprenticeship in the business turns into this oracle of fun.

David: He comes back to Kyoto, he takes over the family business. He waits until Sekiryo finally dies, which the writing was on the wall happens in 1949. As soon as that happens, he institutes a massive purge. He fires not just anyone who is loyal to Sekiryo in the company, he fires every single manager in Nintendo, just decapitates everybody. He doesn't literally burn the company to the ground, but he just about burns the company to the ground.

Ben: There's basically no more institutional memory of a leader other than him in the entire organization.

David: Yes, and there is no question who the new Yamauchi is going forward and who is in charge here. Totally crazy.

Ben: We're in what 1950-ish when he takes over?

David: 1948–1949 when this happens. Hiroshi, though, like you said, for the first time, he's 21 years old. He's a young man. He doesn't want his life to be shackled by what Nintendo and the Yamauchi family has always been historically. He's looking around for ways to make Nintendo his own. Finally, in 1959, the perfect opportunity arises. The Walt Disney Company is looking to enter Japan.

Ben: It's crazy that Disney comes into the story, especially because there are so many parallels between Nintendo's identity as a business, the thing that makes them great, and Disney. It's crazy that what lands on his doorstep is Walt Disney calling.

David: Also, given what Nintendo's business is, which is what we just spent 20 minutes describing. Disney's like, oh, yeah, these are the guys we're going to work with in Japan.

Ben: Right. We're a family-friendly brand that has to protect our brand safety above all else. How about these guys that do business with the mob?

David: But the reason they do it, the way that they want to enter Japan, is with playing cards. Nintendo licenses Walt Disney characters and puts them on playing cards, and they sell playing cards to kids in Japan.

Ben: I got to buy some of these. If these still exist somewhere on eBay, I have to go find some.

David: I bet they do. Some of the documentaries I watched there are photos and video footage of them. You can probably find them somewhere. We got to put these in the Acquired Museum.

Ben: Nintendo-branded Japanese Disney cards.

David: This is what Yamauchi IV I guess at this point in time, Hiroshi, is looking for. This is the opportunity. Not only does this open up a new market and a new distribution channel, the kids market, the toys market, the legitimate retail for Nintendo. There's just an incredible opportunity to draft off the Disney brand. They start with playing cards, then they start licensing from Disney, other kids toys, to sell in Japan. Then they go to the retailers and they say, hey, you like carrying these Disney toys. If you're going to carry the Disney toys, you need to carry some Nintendo branded toys along with them.

Ben: It is amazing. It's the story that we tell over and over and over again on Acquired, where you acquire something, some asset that then gives you a leg-up in a different part of your business. Now it's a self fulfilling prophecy, where that other part of your business is made better. By having a scarce commodity—Disney branded cards—they get power over the distributors. Now you actually have a reason to be in stores. Now that you're in stores, it doesn't matter how you got there. You have that channel. You have those relationships. Especially if you can hold them captive and say, you have to distribute our stuff with Disney stuff, then it's a pretty good bargaining position.

David: During the 1960s, Nintendo transforms itself into a Japanese toy company. They are making things like the ultra hand, which is an extended grabber. I know you did some research on this.

Ben: This is awesome. This guy, Gunpei Yokoi, in 1970 comes up with an idea. We're breezing through history here, but we got to have to, It's 100 years. We went from 1949 with Hiroshi taking over to 1959 when Disney comes in. Flash forward down in 1970. Yokoi comes up with this telescoping fake hand basically as a gag. Hiroshi Yamauchi looks at it and he goes, that looks like a winner. This guy's just so good at identifying things that consumers are going to love, so they market it as the Ultra Hand. Truly, he made it as a gag around the office. They sell 1.2 million products of this Ultra Hand.

They're all looking around and they're like, oh, we should become a novelty toy company, all out. That's what we should do. They come up with I think the 10 billion barrel maze. They have a love tester device that they market. They have a remote control vacuum 30 years before Roomba. They're just coming up with crazy toys in the lab and bringing them into the market.

David: All these gadgets. Because they have these Disney Damocles that they can hang over retailers' heads, they know they're going to get the retailers to carry all this stuff. It's amazing.

You mentioned Gunpei Yokoi. He was a tech on the playing card assembly line, maintaining the machines within Nintendo. To your point, Yamauchi just has this sixth sense for products and for talent. He plucks him off the assembly line and says, you are now the chief designer, the chief engineer for Nintendo.

Ben: That's crazy.

David: Gunpei would go on to design the Gameboy and the Virtual Boy. He would run the Metroid series. He would be the first boss and mentor of one Shigeru Miyamoto. Amazingly now, by the late 60s, early 70s, Nintendo has become a toy company and a very profitable one at that. Yamauchi starts investing in a whole bunch of other stuff. One of the things he invests in is failed bowling alleys.

Ben: What?

David: Bowling was this incredible fad that had taken Japan by hold in the late 60s. All these bowling alleys got built, but then society lost interest in them. There are all these empty bowling alleys. Yamauchi goes and buys up these bowling alleys. He directs Gunpei to say, hey, come up with some gadgets that we can put in here and we can attract people to these bowling alleys.

They decide that they can use some of the technology that Gunpei is building for toys to make indoor shooting ranges, light gun shooting ranges, not laser tag, more like clay pigeons, but simulating shooting ranges indoors in these former bowling alleys. They do this, this goes pretty well, and this becomes another big thing. This is random, Nintendo getting into indoor light gun shooting ranges. But actually, this becomes the critical thing that pushes them into the video game market for a bunch of reasons.

One, this gets Nintendo into the arcade business. What else do you put in bowling alleys and indoor shooting ranges but arcade machines? Gunpei, Yamauchi, and the rest of the company, start making their own arcade games that they can put into their shooting ranges and bowling alleys. At first, these are electromechanical games like Sega. But once Pong becomes a thing and comes over to Japan and arcade video games, they get into it, too. Nintendo starts making their own arcade video games.

Two for Nintendo, these light gun ranges that they start building, they become pretty good at it. They decide that they can export the technology to North America and Europe. This is actually the first product that Nintendo starts exporting out of Japan, this technology. They do it using trading companies to start. They're not setting up their own distribution internationally yet, but they start building relationships with American companies.

And three, this is just unbelievable here. The light gun business gets them into a relationship with Magnavox. Remember Magnavox from the beginning of the episode?

Ben: Yeah, the Odyssey.

David: Specifically for the launch of the Odyssey in America, the Odyssey came with a bunch of peripherals for use in the games, on the console. One of the peripherals was a light gun. Who made the light gun for the Magnavox Odyssey? Nintendo.

Ben: That is the most circuitous path to finding their way into American home video consoles, but it makes sense.

David: You cannot script this any better. Nintendo, who single-handedly in a minute comes in and dominates not just the American, but the worldwide market for home video game consoles and builds this incredible juggernaut around the world, were right there, part of the very first home video game console launched in America by Magnavox.

Ben: Wow. In a way, that lets them observe this market without having to push their chips in on this market.

David: Let's take the story from there. They build this relationship with Magnavox, they see that the Odyssey, despite Magnavox having no idea how to market this thing, is succeeding despite itself in America. They're like, well, we're in the toy business in Japan. This thing might actually do decently here in Japan. They license the Odyssey from Magnavox. Nintendo rebrands and starts distributing the Magnavox Odyssey through its toy retailer channels in Japan.

Ben: I had no idea that before the NES, they had their own Japanese distribution of a home video console.

David: All from these crazy light gun ranges, this is what gets Nintendo into the video game business. They start selling the Odyssey in Japan. Pretty quickly, they actually just license a bunch of the tech from Magnavox and start making their own modified consoles. 1975 is when they licensed the Odyssey.

The next year, in 1976, they take a bunch of that tech and they make their own Nintendo home video game console, the very first one that they make, the Color TV-Game 6. It's just an Odyssey knockoff, just more localized for Japan and maybe a little better tech, but the same thing. It only plays a couple of simplistic games, one of which is Table Tennis. It becomes a huge hit just like the Odyssey. That Color TV-Game 6 sells a million units in Japan. This is transformative for Nintendo.

Ben: What year is this?

David: 1976.

Ben: Okay, this is before the success of the US-based home console rush.

David: Yes, 100%. Nintendo is very early to the market just in their own unique way, isolated to Japan, but they're learning everything along the way. The next year, they follow the Color TV-Game 6 up with a new model, the Color TV-Game 15. It plays 15 games instead of six games.

Ben: I was like, why are they calling it the six? Okay.

David: Remember, these are not cartridge-based consoles yet. You're not selling programmable software for them. That sells another 1 million units. Together, these consoles, like I said, totally transformed the company. They're making much better margins on these things. They can sell them for a higher sticker price than the Ultra Hand and the other toys that they're selling. The shooting gun ranges, that's a fad. That goes the way of bowling alleys in Japan. This is what Nintendo inadvertently becomes. They become a Japanese video game business.

Ben: It was a pseudo importer reseller. That's crazy. By the way, do you know how the light gun works and why that was such a leap forward?

David: No.

Ben: This was a very clever invention by Nintendo's engineers. You could imagine that the way a light gun, the most intuitive way for it to work would be, you take a regular gun that shoots bullets out of it, and instead you make it shoot laser out of it. What that would require is for the TV, the target to have a detector on it, which you really don't want to have to force that constraint. That sounds really hard, especially when you're trying to work with a lot of different TVs.

David: It's ironic that later, Nintendo would force that constraint with the Wii.

Ben: Right, isn't that funny? They flipped it on its head. They figured out that actually, what we should be doing is we should make the gun the detector, and we should specialize what's coming on the screen.

David: That's super cool.

Ben: There's a one frame thing that happens. I think that you can still see this in the early Duck Hunt games. Basically, the screen flashes one frame, where only the target is lit up and the gun is the detector. If in the gun's sight, it sees the set of pixels that are lit on the one frame, then it knows it got a hit. If it doesn't detect those pixels, then it's a miss.

David: I always wondered how Duck Hunt works. I had no idea.

Ben: Yeah, pretty cool.

David: That's amazing. Nintendo, thanks to this relationship with Magnavox, is in this incredibly privileged position in this new industry. They have a bird's eye view into the American home video game industry. They're learning all the lessons from what's happening there. They're also pioneering and establishing themselves as the leader in the Japanese video game industry.

They're in a great spot through all of this. They see, come 1977, when Atari and Warner Brothers releases the VCS 2600 in America, Yamauchi, even despite not being an engineer, is like, clearly this is the future. This piece of hardware not only is so much better than all this dedicated stuff like the Odyssey and what we've been doing that came before, but the business model implications of this, the razor and blades model, the interchangeable cartridges, selling software, we got to get into this game. They also see that things are crazy over in America. Everybody's rushing into this industry.

Ben: They got to be very judicious here. It's a very attractive market to enter, but they have to figure out a way to differentiate and not make all the same exact mistakes that everyone else is making, and Russian with crap products that eventually people are going to stop buying. They have to figure out how to sell something interesting, durable, and unique.

David: Yamauchi makes an incredibly foresighted decision here. He says, we, Nintendo, need to build a programmable home video game console like the Atari 2600. Whereas Atari and all these other American companies, they're rushing their consoles to market. This is, if not shoddy hardware like the development cycles for these consoles, are maybe a year, a year and a half. We have the luxury here in Japan because there's no direct competition. Let's take our time and let's make something really amazing.

Ben: Yup. Not to mention that by taking a long cycle development time, they actually get the benefit of Moore's Law. They get to come out with something a few years later that is much, much better.

David: Exactly. He starts a project in the late 70s, within Nintendo to develop their first programmable ROM cartridge, swappable software, home video game console, but he's willing to take a very long view. He instructs the team, I want this device that we produce to be at least one year ahead of any competitors on the market anywhere in the world, and I want us to be able to sell this thing for the equivalent of $75.

Ben: On top of that, I want us to be unit economic positive on these machines. I want every game system that we sell to be profitable for us. This is completely contrary to the rest of the industry who's like, oh, yeah, this is a razors and blades thing, we're happy to subsidize so that we can sell more games. He's like, we're going to do it all on hard mode, and we're just going to take years to do it. This is 77 when he's saying this. The NES won't debut in the US until 1985.

David: And not in Japan until 1983. It reminds me of the old saying, you can have high quality, you can have cheap and good prices, and you can have something done quickly, but you can only choose two out of three. Yamauchi says, the constraint I'm going to relax here is time, which nobody else in the video game market is doing.

Ben: It's 1977. What are they going to do in the meantime? R&D is super heads down and secretive on building what becomes the Famicom and the NES.

David: Yup. Yamauchi splits Nintendo's R&D teams from one singular team that's working on all of their video game business into multiple teams. He takes the new team, the R&D2 team, and he dedicates them to this home console project. He says, you have years, you don't have an unlimited budget, you have a lot of constraints, but make this thing amazing.

The original R&D team, the R&D1 team, he says, you guys keep working on the line of tech that we already have, the dedicated home consoles, and let's explore some other ways to use this technology to make money.

That leads to the Game and Watch business, which is this total dead end in video games and technology, but was insanely profitable for Nintendo for a couple of years. It played one dedicated game per machine. It actually comes from the calculator industry, it's where they take this tech. It becomes the spiritual forerunner of the Gameboy, but this type of product is particularly suited to the Japanese and broader Asian markets. It's portable, you can play it anywhere, you can play it on the go. It does really well for Nintendo.

Ben: Much lower price point.

David: Much lower price point. They sell millions of these things in the late 70s and early 80s in Japan, which keeps financing the other R&D team. Also, they haven't forgotten about the arcade side of the business, too. Yamauchi spins up a third R&D team just to focus on making arcade titles, because he also knows that software is going to be really important for this eventual home console.

Ben: They're basically saying, we want to learn what games are great, and once we have a stable of those great games, then we can unleash them on whatever our next generation console ends up being. But for now, we need to create a bunch of games in the arcades, in cabinets, so we know what the hits are going to be. I will say, to know what the hits are going to be, basically, none of them were at first. I imagine there was a year at Nintendo over in Japan where they're hitting the oh-crap button, where they're like, we may not have any good games to put on this thing.

David: Fortunately, the console wasn't ready yet. There's one more piece of the puzzle, though, and that's that he needs to get a foothold in the American market so that they can get distribution relationships there and actually be able to enter it.

Ben: Ideally, in his mind to be their own distributor. Nintendo is really obsessed, especially at this point in history with not getting commoditized and not having to fork over 50% to this middleman and from then another 50% to that middleman. It's like, no, we need to get directly to customers.

David: They've been using trading companies to export the light gun tech and other things. They want to set up their own distribution. But grudgingly, the Yamauchi family cycle is going to repeat itself. As much as Hiroshi hates it, he knows the perfect person to set up Nintendo of America, his son-in-law.

Ben: Who does not want to work for Nintendo.

David: Who definitely doesn't want to do it and whose wife, Hiroshi's daughter, absolutely does not want him to do it. Minoru Arakawa. Before we get into the fifth cycle of the Yamauchi family, I don't know if it's a curse or a blessing, probably both. We have another of our favorite companies that we need to thank.

Ben: Before we get into the real meat of the episode and how Mario, the Famicom, and how everything in Nintendo comes to be, it's Vanta time.

David: What a perfect place to talk about Vanta because what Yamauchi is trying to do by setting up Nintendo of America is trying to enable revenue. What does Vanta do? They enable revenue.

Ben: There's that Rosenfeld transition.

David: Most of you know about Vanta by now. They help companies of all sizes scale security practices and automate compliance for all of the most important compliance standards across the industry, so SOC 2, ISO 27001, HIPAA, GDPR, and any other compliance standard that you may need to get certified in in order to sell to important customers. Vanta automates up to 90% of the work required to achieve these standards like SOC 2, and gets you audit-ready in weeks instead of months.

With Vanta, you can get up to 400 hours of your team's time back and 85% cost savings, especially if you're a startup. But if you're a company of any size, you should not have your own team checking all the boxes required for you to become SOC 2 or any other compliant. You should use Vanta and get to enabling revenue with customers that you want to sell to way faster and for way, way, way less cost.

Ben: You can always tell those early-stage B2B companies that there's just not enough stuff on their website yet. There are not enough menus. There are not enough little badges at the bottom saying all the different ways in which they're compliant. You can just tell. This company is probably underpricing their product, they're probably selling to too small of customers. But once you see that footer full of badges, you're like, ah, these guys know how to find revenue.

David: That's a dying breed now because even seed stage companies now can become compliant and be able to sell to highly regulated industries like healthcare, HIPAA, and everything, and it's all because of Vanta. Listeners, go on over to vanta.com/acquired to learn more and sign up. For a limited time, if you use that link, new customers can get $1000 off your Vanta implementation.

Ben: Great deal.

David: A great deal, you will be in a great company. Vanta now has over 4000 customers, which is crazy. When we started working together a year ago. I think it was less than 2000. It's so impressive. Our thanks to Vanta.

Ben: Thanks, Vanta. All right. We're heading into the 80s, it's going to be Nintendo's decade. Over there, they have a four-prong strategy. Bring me to Radar Scope, David. I'm jonesing for it. Listeners, unless you're Nintendo history buffs, you're like, Radar Scope? But Radar Scope would be the ashes from which all of the phoenixes you know about rise.

David: Arakawa, Yamauchi's chosen son-in-law, begrudgingly, who he sends over to set up Nintendo of America, unlike other son-in-laws in the Nintendo family history, has a bit of a different background. He is also from a very prominent, high society, well-respected family in Kyoto, but he left Japan and went to America for his education. He went to MIT, where he was educated as an engineer, and he fell in love with America.

Ben: He may have fallen in love with the distance from his father-in-law too. A whole ocean in the way is pretty nice.

David: This is before he met Yoko, his wife. When he comes back to Japan, he meets Yoko at a Christmas ball while Yoko is in college. Yoko wants nothing to do, just like Hiroshi before her, she wants nothing to do with Nintendo, nothing to do with her father, nothing to do with the family business. She's taken by Arakawa in part because he loves America. He's so different. There's no way that history is going to repeat itself here.

Ben: If I don't want to be involved with Nintendo, then this guy is probably that ticket.

David: They get married and they move to Vancouver, in Canada, where Arakawa becomes a very successful real estate developer. Yoko loves it there. They come back home to Kyoto to visit the family and Yamauchi makes his pitch.

Arakawa's intrigued, but he's got a successful business of his own. He loves his wife. His marriage is very important to him. He knows that if he accepts here, he's going to be in a real tough spot. But Yamauchi says, hey, I'm not asking here. You need to do this.

Ben: And there's a little negotiation. I think they strike an economic deal that makes it very much worth Arakawa's time. Arakawa's strong belief is, I have to be in America and do it my own way, rather than me starting to take over the company in Japan.

David: This is part of the deal that convinces both Yoko and Minoru to do this. Yamauchi says, I'll let you run things your way in America.

Ben: Big concession.

David: I know you live in Vancouver, I want you to move to New York City because New York City is where the toy industry is headquartered in America, and you got to go build relationships there.

They have a mandate to set up Nintendo of America in New York, which they do. At first, there's no console yet. They're not ready to enter the home video game market, but they've got these arcade machines. The way that they're going to build up Nintendo of America is through the arcade business. They do the obvious first thing that makes sense. They hire the guys who had been running the trading company that was importing Nintendo's arcade machines in the past.

Ben: I think they were importing used Nintendo arcade games from Japan, refurbishing them, and then selling them into US bars and arcades. It was this very, almost like a gray market way to acquire Nintendo's cabinets.

David: That was run by two young guys at the time who were from Seattle, University of Washington alums, Al Stone and Ron Judy. That becomes the initial Seattle link for Nintendo of America. They hire Stone and Judy to sell Nintendo's arcade games that they're producing back in Japan. To no one's surprise, they don't sell very well. The games just weren't very good.

There was pretty robust competition, of course, as we talked about in the American market. Arakawa's like, guys, why are these not selling? Run and Al are like, they're not selling because the game sucks. You need to call up Yamauchi-san and be like, hey, send us some better product. They say, what is selling here? We're now in 1978, 1979 in America. What is selling Space Invaders that's made by a Japanese arcade company, Taito. Why don't you get the guys back in Japan to make something like Space Invaders and send it over to us?

Minoru calls up Yamauchi and is like, hey, can you send us something like Space Invaders? Yamauchi doesn't really want to do it because he's like, look, you're just supposed to be building relationships over there. Can't you just use our games? Arakawa's like, no, I really think this is going to sell. I'm going to place a really really big order. I want you to send me 3000 cabinets of a Space Invaders knock off. I really know that this is going to work.

Ben: Yup. We are your boots on the ground. We know this market. It has to work.

David: I'm putting my reputation with you on the line. I know you don't know me that well as a business partner yet, but I really think this is going to work. Yamauchi says, okay. He directs the R&D3 team to come up with a Space Invaders knockoff, which they do. They make Radar Scope. It's innovative. It has a different perspective. It's not the top down Space Invaders. It's got like a three quarters view quasi 3D twist on the Space Invaders mechanic.

They start producing them in Japan. Unfortunately, to make the games from scratch, build them in Japan, and then ship them over to New York, which takes a long time on the water to ship them—it takes four months—during this time, the American Space Invaders mania peaks and starts to die off.

Ben: This is pretty much the last time that Nintendo will pursue the strategy of something as hot. Every single success that Nintendo has from here on out is from their own discovery of something fun, from being inventive, and from taking risks. That means it will come with failures, too, but from this point forward, they never tried the fast follow clone copy thing again.

David: Totally. When the cabinets show up, Nintendo of America can't sell them. They've got all this capital tied up in this inventory. They only managed to sell about 1000 of the 3000 cabinets.

Ben: They got 2000 Radar Scope cabinets sitting in a warehouse in New Jersey at the current headquarters of Nintendo of America, collecting dust.

David: Minoru needs to call up Yamauchi again.

Ben: It'd be like, you were right.

David: I feel like, about want to put my neck on the line with these Radar Scope cabinets. I was wrong. You can only imagine how this conversation went. He's like, we got to do something. Nintendo of America is going to go bankrupt with all this inventory and these cabinets just sitting here. Can you get somebody to reprogram some new chips that we can insert into these cabinets and just try and move this inventory?

Ben: Radar Scope is this game that has I think one joystick and maybe two buttons? Can somebody come up with a game that leverages that, most of the same chips that are on the motherboard, and leverage basically the assets we've got, to create a new game out of this thing?

David: Things are so bad. Yoko at this point is so pissed. She takes the kids and basically moves back to Japan. She's like, I can't believe this has happened. We're out of here.

Ben: This is a pretty constrained problem, too, because you basically are saying, hey, create a different shooting game. When you only have the joystick and a couple of buttons, basically every game at the time is, okay, use that to move the gun to where you're going to shoot it, then press shoot, and then maybe you have a different button. You're giving a pretty prescriptive order. You're giving a pretty narrow set of things you could turn this into and less.

David: Yamauchi is so pissed. He can't take anybody off the console project. Those are his best engineers who couldn’t maybe pull some rabbit out of the hat here. He goes to Gunpei and he's like, my dumbass son-in-law-over in America, I got to give him something. Can you give me like a janitor or somebody to make a game here? Gunpei's like, I literally can't take any engineers.

At the time, only engineers made games. There was no game designer role. It was just the engineers who made the games. I can't give you engineers. We do have this young kid who I brought onto the team, who is our design guy. He is here to help with the hardware design.

He worked on the Color TV-Game design, the hardware, and some of the user interface. He's pretty talented. He's not an engineer, but he's been wanting to make a game. I can give you that guy. Yamauchi's like, fine, whatever.

Ben: Importantly, this isn't the B team. This is the unknown.

David: Right, this is literally like the janitor. That guy's name is Shigeru Miyamoto. This is how he comes to make his first video game.

Ben: Yes. If you don't know that name, which I suspect 90% of you don't.

David: I suspect 90% of people do know that name.

Ben: That's the thing. I'm really curious if people are like, this is Miyamoto, or if people are like, what the hell are you talking about? I think for those of you who know your Nintendo history, David just said, and this is how God is discovered. But for those of you who don't, this is how God is discovered.

David: The tablets come down from the mount and Moses brings them down. Miyamoto, Moses. The game that young Shigeru Miyamoto makes to replace the Radar Scope software in these cabinets is called Donkey Kong. Donkey Kong, with itself, goes on to earn hundreds of millions of dollars immediately in North America alone. That totally saves Nintendo of America skin.

It earns $180 million the first year, another $100 million the second year in arcades. It becomes such an incredible franchise and IP, which we'll get into in a second. Just this game, the original Donkey Kong, has grossed over $5 billion alone in the decades since on all the platforms it's been released.

Ben: David, the year that it was released in 1982, it made more money than any film released that year, except for ET.

David: Even more importantly, though—I'm so curious what percentage of our audience already knows this and what percentage doesn't—the playable character, the game Donkey Kong, is actually named after the villain. The playable character in this game...

Ben: Is this very small, big headed, wearing a hat, innocent, nameless carpenter. Listeners, you might have thought that I was going for an Italian plumber named Mario, but here we have proto Mario. We have Jumpman the carpenter.

David: What's going on here? Like I said, up until this point, everywhere in America, in Japan, the only people who made games were engineers. Miyamoto has this incredible quote about this. He says, until Donkey Kong, programmers and engineers were responsible for game design. These were the days when engineers were even drawing the pictures and composing the music themselves. They were pretty terrible, weren't they?

Specifically, like we've been talking about all episode, there was no story. The whole point of making the game was to make it technically competent and something competitive that would have enjoyable gameplay for mostly, to suck up quarters in arcades.

Ben: It's also a freaking miracle that they work at all. You think about the very early technology involved to layer on more hard things on top of making this thing work, make it, make people enter a flow state when they're playing it, make it repeatable over and over again, and add story. Like, no, arrange the chips in a way that it works and doesn't break quickly.

David: Miyamoto on the other hand, he's not an engineer. He's a designer. He thinks games can be an art form. When Yamauchi gives him the chance to make a game, he's like, finally, I can bring my genius to it. He's not a self-conceited man—I'm sure he didn't think of it that way—but he has a very different vision for what a game can be.

Here's what David Sheff who writes Game Over, which is a great book, writes about the conversation that Miyamoto and Yamauchi have when he gets assigned to make the game. Miyamoto boldly told the Nintendo Chairman that he would enjoy creating a game. However, he said, the shoot-them-up and tennis-like games that were in the arcades at the time, were unimaginative, simply uninteresting to many people.

He had always wondered why video games were not treated more like books or movies. Why couldn't they draw on the great stories? Some of his favorite legends, fairy tales and fiction, King Kong, Jason and the Argonauts, even Macbeth. This is exactly what Miyamoto does. He makes the first narrative-driven video game.

Ben: It's a super simple narrative and a very thin character. This notion of Jumpman running around at the bottom, trying to save this nameless princess from an ape that's throwing barrels, it's not a lot of story.

David: It's his girlfriend.

Ben: Really?

David: Yeah.

Ben: Originally, it was not a princess?

David: Here's the story that Miyamoto comes up with for the video game. A regular every man—Jumpman—has a pet gorilla who he keeps in his house. He's not very nice to this pet gorilla. He doesn't treat him very well. One day, the gorilla escapes and kidnaps our protagonist's girlfriend as revenge for not being treated well. It's important, the gorilla does not want to hurt the girl.

Ben: That's right. Her name is just Lady, right? They don't even name her.

David: She was Pauline in the American version.

Ben: Okay.

David: The gorilla—this is important—does not want to hurt the girlfriend. He actually likes her quite a bit. He just wants to stick it to the protagonist. He runs with the girlfriend into a skyscraper construction site, climbs up to the top of this half constructed skyscraper, and starts throwing barrels and construction equipment down at the protagonist as he tries to chase them up. Your goal as the player is to reach the top of the construction site, defeat the gorilla, and save the girlfriend, which is incredibly simplistic today, but nothing like this had ever existed before.

Ben: And so wonderfully innocent and convoluted, too, everything about that, you're like, what? That worked? That was the best story you could come up with?

David: Yup. But despite its wackiness and simplicity, it's a classic three-act story. There's a beginning, dramatic tension is introduced, there's a middle and a struggle, and then there's an end, a victory, and a resolution.

Ben: It's also worth saying, Miyamoto came up with all this within the constraints of what Radar Scope's hardware was. He managed to figure out a way to retrofit this hardware to create a non-shooting game and come up with a completely new game mechanic of climbing these ladders and avoiding the barrels using the same controls originally intended for Radar Scope.

David: While Miyamoto, like you said, not even the B Team or the C Team, just the unknown team, is working on this game back in Japan.

Ben: Team wildcard.

David: Team wildcard. Arakawa's totally freaking out back in New York. His wife is going back to Japan, taking their kids. He's like, all right, I don't know if this is going to pan out here, but I know one thing. If we're going to save both the business for Nintendo of America and my marriage, we have to leave New York. We got to go to the West Coast of America because the fatal mistake that we made with Radar Scope is we placed this huge order with a four-month lag time. We couldn't get any feedback. We couldn't get any test machines into the market.

Ben: I assume they had to go through the Panama Canal.

David: I assume so, right? You can't just put all this stuff on an airplane and send it there. He says, we got to leave New York for business reasons. We love being in Vancouver. We don't like New York. We can't move to Vancouver because we have to be in the United States for what we're trying to do here, but we can move to Seattle.

Ben: Nice and close to Japan, easy shipping times.

David: Easy drive to Vancouver. Yoko can hang out with all her old friends back there. This will be great.

Ben: Microsoft was 7–8 years old at this point. They're starting to be some tech talent. There are the former Boeing engineers.

David: Absolutely, and it's even more perfect. Our distribution guys who we hired and brought in house, are from Seattle. It's perfect. We need to move there. While all this is going on back in Japan, they moved the company to Seattle. They lease a warehouse space in Tukwila. For folks who don't know Seattle real estate, Tukwila is just south of the city by the airport. It's very industrial.

Ben: It's a great place for your video game warehouse.

David: Great place for your video game warehouse, exactly. They ship the cabinets across the country by railroad from New Jersey to Tukwila. They're all hanging out there. Yoko and the kids come back. They're like, okay, great. Then the ROMs show up with a replacement game for Radar Scope, with Donkey Kong. They plug them in, they all huddle around, they start playing, and they'll like, WTF. What is this? We're screwed.

Ben: It's super different. They weren't really told what to expect. They basically get these conversion kits that show up via the freight over the ocean. It's got instructions of, here's all the ways to replace all the components with these other components. Here's the way to load the new music on. In fact, there were rumors that this was going to be a really great recognizable IP to help with sales, that Nintendo actually had some pre-existing relationship with the owners of the Popeye IP.

David: Yes, they were working on a Popeye license with King features.

Ben: Yes. This wasn't going to be like Jumpman, Lady, and Donkey Kong

David: It's a nonsensical name for a gorilla.

Ben: This was going to be Popeye, that was going to be Olive Oil instead of Lady, and that was going to be Brutus, the kidnapping character. That would sell well to an American audience. This thing arrives with these brand new characters that no one's ever heard of, and they're crap,

David: We are totally screwed. Stone and Judy threatened to quit. They're like, this is not going to go anywhere. But they've got this kid. They've hired a couple of kids in Seattle to work in the warehouse, move stuff around, and get it shipped out.

There's this one kid named Howard Phillips working there. He's just a total arcade nut and loves video games. He plays it in the warehouse and he's like, guys, this is the greatest game I've ever played. This is a work of genius.

Ben: The game mechanics are a work of genius. Even though at first blush, you're like, this is not the type of thing that is selling well, once you start playing it, you're like, oh, everything about it is thoughtful. It doesn't get boring right away. The music is continuous and recognizable without getting repetitive. There's a random variable, so you can't just beat it the exact same way every single time. If you memorize all the right things to press, it actually has a lot of art to it, exactly what Miyamoto set out to do.

David: Yup. Not only does it have the narrative and art, it's exactly what you're describing. This thing is really fun. If you pick up and play it, you can intuit really quickly how it works, how to play it, and you can just start having fun.

Ben: There's a maxim in the video game industry that a great game is easy to play, but hard to master, and that is exactly what this is.

David: Yup. Philips in the warehouse is really playing. He's like, guys, this is really good. They're like, okay, well, let's take it to a couple of bars around Seattle, just set it up, and see what happens. Just like Pong back in the day, this thing becomes a quarter magnet. Phillips' intuition was right. None of the senior guys, none of the older guys, Arakawa, Stone and Judy, they didn't get it, but the kids did.

On the back of that, Phillips ends up becoming Arakawa's most trusted adviser about games. He becomes Nintendo's Game Master, he becomes a hero in Nintendo Power, all of this. He's like a national celebrity. It's incredible.

The Nintendo of America management, though, does decide one thing. They're like, we get okay that there's this narrative revolution here with this game. I don't think it's going to work here if we call the protagonist Jumpman. We need to give him a little more of an identity than that. They're casting a vote trying to decide what to name this character.

Ben: By the way, I should say, I was shocked that Donkey Kong predated Mario. His name is not on the cover art in the very first game he appears in. Of course, he doesn't have a name.

David: The legend goes that as they're debating this, the landlord of their warehouse in Tukwila, either shows up or sends a letter. It's unclear.

Ben: Shows up because they were way behind on rent, because this freaking company didn't make any money.

David: Demands the rent because they're late.

Ben: The way I know he shows up is because he starts jumping around, ranting, raving, and waving his arms in the air. He's super animated, they can see him there, and he's got this big bushy mustache.

David: He's this Italian guy named Mario Segale. This is how Super Mario gets his name.

Ben: Amazing.

David: Totally amazing. They named the girlfriend Pauline. I think she was either the wife or girlfriend of one of the guys working at the company at Nintendo of America at the time.

Ben: They named her Pauline because the warehouse manager who was taking a lot of the heat from Mario Segale, directing it away from the Nintendo guys, and taking the hits for them, his wife was named Polly, so they named the character Pauline after her as a thank you to him.

David: Nice. Nintendo has a history of doing this with their characters. One more thank you naming of a character is going to come up in just a second here. The game sounds like wildfire, like we said. The 2000 former Radar Scope machines fly out of the warehouse. They order more. They end up selling thousands and thousands of these.

Ben: It expands the TAM of who plays video games, too, that's the other thing. It's not just for boys anymore.

David: It's not just teenage boys anymore or people in bars. Irony of ironies, Taito, the Japanese company that made Space Invaders, they call up Yamauchi and they're like, hey, we're the really good Japanese arcade game manufacturer now. You've made this hit arcade game. Can we buy the rights to it from you to distribute it for Nintendo around the world? We'll pay you a ton of money for it.

Yamauchi is inclined to sell because remember, he doesn't really care about the arcade business. He really just wants to set up Nintendo of America to get the distribution arm for the console that's coming, but he lets Arakawa make the final call. Arakawa says nope, we're going to keep it. We're going to distribute it in-house at Nintendo of America. Of course, that ends up being totally the right decision and re-earns Yamauchi's trust from him.

Ben: It's a multibillion dollar correct decision.

David: Multibillion dollar correct decision. The other hilarious thing that happens is MCA Universal and the legendary Sid Sheinberg, who we talked about with Michael Ovitz over at MCA Universal, of course sees what's going on with Donkey Kong. He's like, I'm going to make some money on this.

Ben: He's like, wait, wait, wait, wait, wait. Big gorilla thing all the way at the top of a building named Kong.

David: It sounds like King Kong, which I think I own the rights to.

Ben: This is my circus and this is my monkey.

David: I think we talked about this with Michael, but this is where it comes out in the court case. Sid would refer to the legal arm of MCA Universal and their legal suit activities as a profit center for the company. He files suit against Nintendo of America for infringing on his King Kong trademark. Nintendo, led by Seattle lawyer Howard Lincoln, who would go on to succeed Arakawa as the president of Nintendo of America.

Ben: I think Howard Lincoln was the personal lawyer first of the two guys who ran the import distribution business.

David: That's right. Lincoln sets Nintendo of America up with a great antitrust lawyer to fight off MCA, which is a crazy decision. They should have just settled with MCA.

Ben: Right? Tiny companies that are not doing well getting sued by very dominant global entities like MCA Universal. You roll over.

David: Yup. Lincoln sets up Nintendo with a great antitrust lawyer, John Kirby. He and Lincoln, together, team up and they fight off Sid Sheinberg and MCA Universal. They ended up winning in court the case, and it hinges on. They discover that Universal doesn't actually have the trademark for King Kong.

Ben: Because it was public domain.

David: Exactly. They knew it, too. Sheinberg knew it.

Ben: That's the thing. The judge slaps him across the face. He's like, you guys knew you were in the wrong here. You've been suing this company and all their partners just to try to be extractive, even though you know you don't have a case. I can't believe you followed up with this.

David: This is where the profit center language comes out.

Ben: Yup. They're wrong on a bunch of vectors, too. They're like, wait. One’s a gorilla, one’s an ape. The other argument that John Kirby finds because John Kirby flies to Japan and starts interviewing a bunch of people at Nintendo to try and mount the argument of like, they didn't know, of course, they didn't reference King Kong IP.

He's in Japan, he's looking around, and he's like, wait, in Japan, they use Kong to describe big monkeys generally. That's a word that's commonly used, so he uses that, too. He's like, this thing was invented very quickly by a small team in Japan using common parlance. The judge just serves MCA Universal. He's like, you guys are dicks and you knew it. You were wrong and you owe all their legal fees.

David: Amazing, which is not normally what happens when MCA Universal goes to court.

Ben: No. As a thank you, Nintendo goes to John Kirby a few years later and says, we've got this great game in development. We're going to name the protagonist after you, and that is how Kirby got his name.

David: Great Smash character.

Ben: Yes. Yeah, a lot of jumps. Okay, we're at this point in time where Donkey Kong sold like gangbusters. They know they've got a hit on their hands. There's potential for these characters to really embrace their own storylines. Their strong incentive by Nintendo, the parent company in Japan, to really flush this all out because they've got the Famicom nearing release. They're trying to figure out, is this thing that Miyamoto came up with on a lark, can he keep doing it? Should we turn the keys over to him creatively and say, hey, see if there's a there-there for this to be the centerpiece of our launch of our console.

David: Which they do. Miyamoto makes a couple of more games. He makes the sequel, Donkey Kong, Jr. That also does really well. He makes an actual Popeye game. They finally get the license. They got in the same vein. That's a footnote in history. In 1983, he makes the first dedicated Mario game, Mario Brothers, as an arcade game.

Ben: Super Mario Brothers, right?

David: They're different games. Mario Brothers was an arcade game that Miyamoto made. That's what introduced Luigi and you had two plumbers. This is what canonically made them plumbers. The setting was underground and they had green pipes. That's how they became plumbers.

Ben: Side note, when they came out with this game, the Mario Brothers, people were like, oh, wait, the Mario brothers, so Mario is the last name? Nintendo confirmed it. They're like, wait, so that guy's name is Luigi Mario, and that guy's name is Mario Mario? Nintendo was like, correct. I think they've maybe changed their stance on that over time.

David: Amazing. What a Nintendo of Japan thing to do. I love it.

Ben: Yes, exactly.

David: Yes, it's clear that Miyamoto has got the golden touch here and has created this whole new discipline of game design, where the same principles as engineering apply. Yamauchi completely understands this, just like he understood with Gunpei Yokoi that there are these certain engineers out there who are so talented and so creative, that they can do things and enable things with technology that nobody else can do.

The same dynamics apply to game designers. There are very few Shigeru Miyamotos out there. The value of what they make is worth many, many multiples of what every other game designer out there makes.

After Miyamoto proves that he wasn't just a flash in the pan, Yamauchi creates a fourth R&D division within Nintendo. It puts Miyamoto in charge. The sole purpose of this new R&D4 unit, which would later become the legendary Entertainment Analysis and Development group within Nintendo, the sole goal is to make games and to make the very best games in the world.

Ben: Their manifesto really ends up becoming fun first. That sounds obvious, but in a way, they're zigging where everyone else is zagging, where a lot of other game designers at this point in history are starting from a place of, we need to make a game that's in this category, other people have made this game and it is successful, or games that are great today involve this set of things that everybody thinks you need for a game.

What the team that Miyamoto is leading is saying, we are on a quest to be inspired, find fun, and then we will build exactly the right window dressing around that fun, that real kernel, that core mechanic that we love, and no more. We don't need to do any of the other stuff on top of that. If it's fun, if it continues to be fun, and it's super replayable, then our mission is accomplished. It is a very, very, very different approach to how other people were designing games.

David: Exactly. Yamauchi has this great quote about Miyamoto and the Nintendo philosophy of what makes a great game designer. He says, "An ordinary man cannot develop good games no matter how hard he tries. A handful of people in this world can develop games that everybody wants. Those are the people we want at Nintendo." It's just so wild that Yamauchi never played a game in his life.

Ben: That is actually true. We haven't really harped on this yet, but this guy led Nintendo through its heyday, invented the modern Nintendo, found the talent to design and market all these games, and never played any of them.

David: Yes, but he totally intuitively grasped all these principles that would just come to define not just the video game industry, but all technology industries. Amazing.

Ben: That quote is less about fun, what defines fun and their philosophy of building, and more about like, most people don't have what it takes and Miyamoto has what it takes. We've got Miyamoto, so good luck.

David: It's true. I think fun and that brand of fun is the Miyamoto and Nintendo style of game design. There are other brands of game design. Folks over at Square and Enix in Japan with the Dragon Quest series and the Final Fantasy series, Hironobu Sakaguchi, who was the father of the Final Fantasy series, would probably have a very different take on that, but he's equally a genius. There are these few people who are just the very best in the world at what they do, and nobody else can match them.

We're now in 1983, and all the pieces are coming together. Nintendo's got the games. They've got the IP. They've got the creative genius in Miyamoto running R&D4. They've got the distribution network that they've always had in Japan. Now they've got it set up in North America as well. The technology is just about ready.

The R&D2 team has accomplished something nobody else can or would for years in the industry. They've created a home video game console that is not just a year, many years ahead of the competition, and will sell for cheaper and profitably.

There are so many of these unbelievable moments in the Nintendo story. The way they do it, that it takes them years to come up with, is they realize that the brute force way of accomplishing the year-plus ahead of the competition directive that Yamauchi gave them would be to get the fanciest, fastest, most Moore's Law enabled, ahead of the curve processor out there, but that would kill the bill of materials. That would make it way too expensive.

They come up with this incredible innovation. They realize, okay, we're constrained on cost, we can only use cheap off-the-shelf at this point dated technology for the CPU of this machine. Up until now, the CPU is everything. The CPU was the brain of the computer. We're in the 80s, even through to the 90s. Remember Intel's marketing, the PC industry, and the CPU was so important?

What the Nintendo team realizes, even though this is a programmable console, we're doing specialized applications for gaming. This doesn't have to be a machine that can also do your spreadsheets. We can pair a cheap CPU with a secondary processing unit within the machine that they dub the PPU, the picture processing unit. Maybe I'm wrong and this is why nobody talks about this, or maybe we've stumbled onto something incredible in history that just everybody overlooked, I think this might be the first example of a dedicated GPU in a piece of hardware.

Ben: Interesting. I wonder if that's right.

David: A programmable GPU. Let's unpack this a little bit. The Atari 2600 had a CPU that did most of the work. It also did have another chip that interfaces with the television. Atari called this the TIA, the television interface adapter. There was no memory on this TIA chip. It was literally just there to draw the graphics that the CPU is outputting to put on the television screen.

The PPU that Nintendo designs and develops is its own programmable chip that sits next to the CPU within the NES. It has eight bytes of memory, and it's dedicated to processing the graphics that get output on the television. It has specialized circuitry, both for doing the backgrounds of the games and for processing the sprites, which are the characters, the movable items on the screen. I think this was the first example of a machine and an architecture in history, where the workload was split up like this because it was a decade later when Nvidia came around and invented the GPU.

Ben: Which is farcical.

David: Of course, they didn't. It wouldn't be until that time when people would think about using this architecture in computers and PCs. But in this subset of the computing market, it was Nintendo.

Ben: I think you're right. I can't think of a counterexample off the top of my head or where a counterexample would even exist.

David: Right, that's what I thought about too. I'm like, I can't think of anything else. Again, it is technically true that the Atari and other consoles had chips that handled the graphics output from the CPU, but they weren't programmable, they didn't have onboard memory, and they weren't doing any of the processing of the graphics.

The PPU at the NES is actually doing a lot of work. All came about is this necessitated by this constraint that Yamauchi put on the team of like, this has got to sell for less than $100.

Ben: It's super clever. The famous thing that Nintendo also went on to do, and I'm very curious if you know how this came to be, is that their games are optimized for fun, not to show off the hardware. They're always able to do what translates very poorly to the US as lateral thinking of seasoned technology, that it's about inventiveness.

David: I think the literal translation is withered technology.

Ben: Withered technology. It's not about using state-of-the-art chips. It's not about using the most expensive hardware. It's about how clever, inventive, and fun can you be with it. It sounds like the first example of cost savings was around this PPU.

David: It actually was the Game and Watch. Gunpei Yokoi's work on the Game and Watch, which he's the author of this philosophy within Nintendo, and that's what led him to that. He's like, oh, we'll take this calculator technology and apply it to games, and we can use this lateral technology to make something fun while keeping the cost down. It's the same thought here. The CPU that they end up using in the NES is a slightly customized, but basically off-the-shelf MOS Technology 6502, which, by this point in time, is a very standard off-the-shelf CPU used in thousands of applications around the world.

Ben: It's like how the Switch processor is like a circa 2014, Android phoneship.

David: And a crappy one at that.

Ben: Okay, they already were fully embracing the idea that we actually don't need the most expensive hardware to create the most fun experiences.

David: In this case, it was really interesting that the NES had graphical capability literally years beyond any of its competitors, but it did it with cheaper technology, and that was the amazing innovation that enabled a bunch of things. Most importantly at the outset for the Famicom and NES, it meant that this new console would be able to have totally 100% accurate ports of arcade games.

When arcade games would come to other home consoles like the Atari 2600, they had to be dumbed down a little bit because the hardware couldn't handle it. When you're making an arcade cabinet, you can have dedicated customized chips, systems, and circuit boards for that game, which allow you to do better graphics, more fancier stuff. If you're then trying to bring it to something like the 2600, you're going to have to make a bunch of compromises. The NES was able to have the best ports of Donkey Kong, Mario Brothers, the Nintendo titles, but then the third-party titles, too.

Ben: It's so interesting. It makes a lot of sense with the way that cartridges work, too, because unlike CDs, where you know, in the modern era, you're reading a game off of some media, loading it into memory and then executing it on the hardware of the actual platform of the console. In the cartridge era, the circuitry was in the console. Everything loads instantly because you were literally playing the game on the hardware within the cartridge. It's this perfect marriage of the circuitry in the cartridge and the circuitry in the console itself that creates exactly enough resources to play that game and nothing more.

David: The wild innovation (technology-wise) that comes out of Nintendo at this time is just incredible. They do stuff later in the Famicom and NES's life cycle. I think with Super Mario 3, the NES is old in the tooth, the Genesis is out at this point, and the graphics aren't industry-leading like they used to be. They start putting computing chips on the cartridges to help the console. Because it marries together in the same system when the cartridge is in the console, they do some similar stuff with Zelda.

Ben: Okay, take us to 1983. Take us to the launching of the Famicom in Japan.

David: On July 15th, 1983, after years of work, Nintendo finally launches the Famicom, the Family Computer, Famicom for short, in Japan.

Ben: Because they had broader ambitions than gaming.

David: Right. They had zany stuff, they thought like, oh, this is so powerful with what we can do with these two chips. We're going to give it a keyboard, we're going to be a Trojan horse into the home, all the stuff that Sony would do stupidly later. Nintendo originally wanted to do that. They ended up cutting all of it to save costs. They still don't get the machine under $100 in Japan. It retails for ¥14,800, which is $110–$120 at the time, but still way below any of the competitors on the market and way, way, way better.

The first shipments in Japan immediately sell out. They sell 500,000 units. When they launch, then they have to do a recall. There's a fault in the motherboard because it's such a complex system, and they hadn't worked out all the kinks when they launched it. It's like the famous Tylenol case. They do a nationwide recall. They recall every Famicom system in Japan.

Ben: They don't just replace the one broken chip, they strip out the entire motherboard and replace every motherboard on every single unit to show people like, we're really serious about quality.

David: Yup. Starting from the summer of 1983 in Japan, right as the video game industry is dying in America, this rocket ship of Nintendo and the Famicom just takes off in Japan. They sell, over the next two years, every single unit they can make. They had placed a 3 million unit order with Ricoh, the Japanese semiconductor manufacturer.

Ben: Ricoh manufactures them? Oh, my God.

David: Yeah, and Nintendo became by far their biggest customer.

Ben: I used to have a Ricoh camera.

David: That's right. They did a deal with Ricoh to manufacture the CPU and PPU tandem system together. The only way they could get the price down far enough to hit the price point they wanted to retail was to place a three million unit order upfront, which was crazy at the time. It was three million units over two years. They couldn't make them fast enough. They sold out the whole thing. It was incredible.

Ben: Nintendo got so lucky that the Japanese market wasn't saturated the same way that the US market was. They launched into the very best conditions in Japan they could have, frankly not a lot of competitive consoles at that moment.

David: Over the next few years, the Famicom would go on to sell almost 20 million units in Japan. In Japan in the 80s, there were only 38 million households. They get an almost 50% penetration into the Japanese market. Isn't that wild?

Ben: Wow, that is crazy.

David: It just becomes this enormous juggernaut in Japan. Meanwhile, of course, the big kahuna market is the US. There are 90 million households in the US at the time in the 80s. Not just 90 million households, there are plenty of other countries that have 90 million households. There are 90 million US households that mostly, 100% of them have a television, were used to playing arcade games, and knew about the home video game market from everything that had just happened.

Ben: Has the highest GDP per capita in the world.

David: And could afford to buy a console, especially a relatively cheap console like the NES. Not 100%, but 70%–80% of the US market could afford this.

Ben: Yup. Wow, that's crazy.

David: By 1983, everything's all set up and ready to go in America. Yamauchi is like, all right, let's go.

Ben: You got to be wondering, should we pull the trigger? This is a crazy moment to decide like, yes, let's launch. Let's flashback two hours before the Nintendo story and remember the state that the United States was in. They just went from $3.2 billion being the home gaming market size to $100 million. They're burying games in concrete, in landfills, smashing them up, and throwing away consoles. This is 1983, so it's the exact same moment in Japan that somebody—I don't know exactly who and exactly what the story is—is deciding to pull the trigger and say, take the Famicom and make an American version of it.

David: Yes. Arakawa's like, I hear you. I don't think this is the right time.

Ben: That's the crazy thing. This is the thing that I think I couldn't tell between reading stories from the US perspective stories, from the Japanese perspective. Do you have a sense of how that dynamic went?

David: I read so many versions of this, so a lot of this is my speculation. I can't 100% say for sure that this is exactly what happened, but this is how I imagined based on everything I read. I think Yamauchi wanted to do it, I think Arakawa did not. I think Yamauchi overruled Arakawa and said, fine. If you're not going to do it, we're going to partner with somebody who will.

Even though you set up everything to be in-house with Nintendo, set up this whole Nintendo of America, the distribution arm, we went through all this, you proved yourself with Donkey Kong, even though I saved you, but I wanted to sell to Taito and you said that was wrong, I want to get this in the US so badly, I'm going to go around you. Nintendo goes to Atari.

Remember this? We talked about this with Nolan Bushnell and he was like, yeah, I wasn't involved, I was really dumb. He had already left Atari at this point and it was owned by Warner. Yamauchi goes to Atari and says, Nintendo of America is not going to launch the Famicom, I want you to launch the Famicom now in the US.

They basically have a deal done. They negotiate it. This is going to be Atari, under Warner’s nose, that their hardware, the 2600 at this point, is dead. It can't compete with the NES. They also know the market is totally gone sideways. They're like, sure, worst case scenario, we can just sit on a competitor, tie up Nintendo, and not launch this. Best case scenario, this is the Atari and Nintendo Entertainment System.

Ben: Wow. What happened?

David: They basically have a deal done. They are all set to sign it at the Summer CES conference in June of 1983. Yamauchi directs Arakawa and Howard Lincoln to go down to LA and meet with Atari and Warner Brothers. Start the initial negotiations, they do that. It goes well. I'm sure Arakawa's like, I can't believe this is happening.

The Atari folks fly out to Japan and meet with Yamauchi. They get a deal basically agreed to, in principle, where Atari is going to distribute the Famicom not just in North America, but everywhere in the world, except for Japan. They're going to pay Nintendo a per-unit royalty fee. Nintendo would still get to sell the game cartridges.

It actually wouldn't have been a terrible deal because all the money and all the profits are in the game cartridges. But still, talking about history changing on a knife point, this would have been Atari’s business.

Ben: Yeah, and Nintendo wouldn't have had the direct relationship with certainly not customers but not even retailers.

David: It wouldn't have built the brand. All the people are going to get into all the amazing stuff that really Nintendo of America drives.

Ben: It would have been an Atari-branded Famicom?

David: Yup. They're all set to sign this at the June CES show in Chicago in 1983, so summer 1983. By this point in time, the crash is already underway. Atari and Warner are keeping these negotiations going, just keep Nintendo tied up, but they know that they can't actually follow through and deliver on this partnership because in the second quarter of 1983, Atari reports a $283 million loss as part of Warner's earnings in the 2Q of 1983.

The third quarter, after CES, that goes up to a $536 million quarterly loss at the Atari division. A year before, like we said at the top of the episode, Atari had been half of Warner Brothers' entire revenue and 60% of its operating income. Now it's reporting a $536 million quarterly loss. The other shoe is about to drop, they have no power. They can't do anything at this point. It's just a charade.

Ben: This probably would have happened.

David: This definitely would have happened if the timing were different. Maybe it would have, maybe it wouldn't have. I don't know 100% for sure, but I think Arakawa was like, yo, the reason I don't want to launch now is now is not the time to launch this in America, I can see what's going to happen here, so maybe it wouldn't have. If things were different, maybe he and Nintendo of America would have let it from the beginning.

Ben: In a sense, Arakawa was right. The fact that they didn't release what became the NES, the US version, which is a little bit modified from the Japanese one, for another two years.

David: In one very key way, it's modified, which we'll get into in a sec.

Ben: Two years later is a much better time to launch this system.

David: Much better. In the intervening two years, all the revenue and profits that Nintendo of Japan, Nintendo Co Ltd, the parent company, was making allowed the whole company to be in a much better position to whether the investment they're going to have to make to re-educate the American market when they do launch.

Just to put some numbers on that for the first couple of years of the Famicom in Japan, not only are they selling every piece of hardware that they can make. Every console that they sell has what comes to be known in the industry as an attach rate, the number of games that are sold with it, going up to 11 or 12 games per console, not per year, but for the life of the console.

I couldn't actually find what the retail price of Famicom cartridges were in Japan at that time. Let's assume they were comparable to the US, which would be ¥7000–¥10,000, half-ish of the price of the console. If you're selling 12 games at half the price of the console, you're making another 6X the console revenue at 80% gross margins. It's just a cash flow spigot.

Ben: That attach rate is high even relative to the big consoles today. I think PlayStation and Xbox, it's different with the subscription stuff today, but target a seven-game or eight-game attach rate. What did you say at 11-game attach rate?

David: Eleven to 12.

Ben: Yeah, it's nuts.

David: Totally nuts. Even more importantly, though, building up to an eventual US launch, it's during those couple of years from 1983 to 1985, that Miyamoto and R&D4 start churning out an existing library of just amazing games. Duck Hunt, Super Mario Brothers, which is the first Mario game like we know it today.

Ben: Absolute smash hit, side-scroller, platformer. Yes.

David: You know what it is. The Legend of Zelda, which actually was the launch game for the Famicom Disk System in Japan, which we won't get into here. The Legend of Zelda was the best thing to come out of it. Let's put it that way.

Super Mario Brothers, for a long time, was the top-selling video game in history. Over the lifetime of that title, it sold over 60 million copies, obviously across multiple platforms, not just the NES.

Ben: Of just Super Mario Brothers 1.

David: Super Mario Brothers 1, 60 million copies. Duck Hunt sells 28 million copies. Later, Super Mario Brothers 3 would sell 24 million copies.

Ben: Keep in mind listeners, there are 90 million households in the US.

David: Right. This is the point we're making earlier that Yamauchi understood. They're making billions of dollars per game. That takes Miyamoto and a small team at this point in time, somewhere between six months and a year, to make these games.

Ben: There are some games that take four or five years.

David: Right. But even in just those two years from 1983 to 1985, Duck Hunt, Super Mario Brothers, Legend of Zelda, launched during those two years. Actually, Zelda might have been a little bit later, but that's billions and billions of dollars. It's incredible. When they're finally ready to launch in the US in 1985, they've got so much firepower to bring to bear here.

Ben: They do a few things differently when they're developing the NES. They take away the word computer, which is an important nod to, we wanted this thing to do all sorts of stuff, to have check stocks and weather. I even think it did some of that in Japan by this point.

David: It did, yeah.

Ben: They did have the ability to connect to your phone line in a pre-internet way and get some of these services. But they launched in the US and they're like, this is an entertainment system. Congratulations, you've just bought the very best way in the world to play video games. For the US version, the NES also had removable controllers. They were hardwired in on the Famicom in Japan. And in the US, an important difference, the cartridges had a lockout chip.

David: Yes, the critical difference. That brings up the next pillar of the unbelievable Nintendo business model that we need to talk about, third-party licensing.

Ben: This is probably a place to talk generally about the role of Nintendo of America versus the Japanese parent company. To this point, what we've basically talked about for Nintendo of America is they were a distributor. They were a regulatory arm, they had to pay payroll, and they had to do that in US dollars for us employees. Also, they set up the distribution network and had some opinions on a go-no-go decision of whether to launch in the US. But they aren't doing a lot of product-specific work.

David: Or business model. Yamauchi definitely thought of Arakawa and Nintendo of America, despite him being his son-in-law already. Maybe because he was his son-in-law, I just thought of them as my American distribution network.

Here's where things start to change. Yamauchi did know and had learned from the Atari third-party licensing business model that we talked about with Activision and all that, that that was an incredible cash flow stream and point of power. He knew that even he wasn't going to be able to get all of the elite game designers in the world to come work for Miyamoto and Nintendo, but he didn't know that he could get all of the elite game designers in the world to publish on the Famicom.

He sets up third-party licensing in Japan. The first two licensees are Namco, the Japanese arcade game company that made PacMan, and Hudson. They were established companies, especially Namco, big existing companies, video game companies in Japan. Before publishing on the Famicom, it transforms their business when they published their first titles as third-party licensees with Nintendo. Konami, which is another Japanese game developer that listeners might recognize, once they start publishing in Japan on the Famicom, their revenue goes from $10 million a year to $300 million. This is how powerful what they built is.

Ben: This is how consumers want to play video games. If you make a video game, you should probably figure out a way to go to market on this.

David: This is the power of a platform and a network effect in the video game console business. Yamauchi gets all this. The terms that he sets up for the initial licensees in Japan, he just copies the Atari business model. They pay Nintendo a 20% royalty on their revenues from the games, and that's it. Great cash flow stream for Nintendo, wonderful, and all that, but they could be doing so much more.

Indeed, the next set of licensees in Japan, Nintendo ups the cut to 30% that they take and says, oh, by the way, only we can manufacture the cartridges. You got to buy the cartridges from us. You can't make them yourself, too, and we're going to make a profit on that, too, so like, good.

Ben: Which at this point is just contractual, it's not a technical limitation.

David: Exactly. There's also no legal structure that they've set up in Japan that prevents anyone else from unofficially making and publishing games for Nintendo. A gray market emerges of developers who say, we're going to make Famicom games, but not work with Nintendo, and sell them ourselves. Famously, one specific company from Taiwan called Hacker International starts making both pornographic and gambling games. Super ironic given Nintendo's origins.

Ben: Nintendo, meanwhile, has drifted very Disney, very Apple, and their family friendliness, so this is so antithetical.

David: Strict censorship, all of this stuff that we think of Nintendo today. They've been in the toy business for decades at this point.

Ben: By the way, this sounds hard to do. You have to figure out how to manufacture the correct sized plastic and the correct motherboard with all the correct pin connectors. If you don't have a factory setup to make Famicom cartridges, creating that sounds really hard.

David: But the economic incentive to do so is worth it. This market is so big. Companies like Hacker International are making tons of money selling their own cartridges directly and not paying a dime to Nintendo. Meanwhile, they've got this brand problem that's emerged and all this stuff. If they're not careful, even though the Famicom is so advanced and so superior, you're not going to end up with the same thing has happened in America in 1983 with a video game crash, but you're going to have some of the same problems if you don't control the ecosystem of publishing around your platform.

Nintendo of America, when it comes time to launch what would become the NES in the US, they come up with maybe the most genius inversion of all time. They say we should engineer a lockout chip that you are referring to into the hardware and the software. It's actually unclear to me if that idea came from Japan or from America, but the Japanese engineers implemented it. This is a specific chip in the console that needs to handshake with specific chips in the cartridges for the new systems in America that will lock out any not official Nintendo-approved cartridges from playing in the console.

Ben: I don't know if it's actually how it works, but it's effectively a Nintendo signed cryptographic thing. Unless you actually go through Nintendo to make sure you get the specific chip with the specific cryptography and put it in the cartridge, it's not going to run on them.

David: Yup, totally. Actually, later versions of the Famicom in Japan would also include a lockout chip on them, so they try and retroactively also bring this to the Japanese market. Nintendo of America is like, obviously, a lot of people in the ecosystem are going to hate this. What if we market it, though, to consumers as this is a good thing? We know that you consumers got burned by the glut of mediocre software in the last video game above all. We Nintendo are on your side.

We're going to make sure that doesn't happen here. This is our Seal of Quality, the Nintendo Seal of Quality that we are promising to you, our customers, that only the very best highest quality software and hardware peripherals are going to come out for your system. This is absolute genius.

Ben: This is the exact thing that Apple steals from. This is the exact party line, this is the exact strategy. When they launched the App Store, to this day, this is the exact reason that they have to justify it for privacy, for security. This is for the benefit of our users. Side loading is the worst thing ever.

I watched Craig Federighi give a talk on stage in Lisbon two years ago, talking about how sideloading or external app stores would be the worst possible thing. Apple generates tens of billions of dollars a year from the 30% of everything that runs through their app store.

David: They stole it all from Nintendo of America.

Ben: It is to the number, the same thing that Nintendo was getting. It was that 30%.

David: It's so good. Nintendo of America doesn't stop there. They're so audacious with what they do, but they could get away with it because nobody cared in America. It was a dead industry.

Ben: Also, they had a great device. Again, the iPhone parallel here, Steve Jobs always said this is five years ahead of the competition. I think that ended up being, round it maybe a year or two, but basically right. The Famicom was five years ahead of the competition and consoles. They go and they have the very best device on the market that everyone wants, you aggregate all the users, and you can do whatever the hell you want to your developers.

David: Oh, my gosh. They just make money six ways from Sunday on this. It continues, the legal innovations of Nintendo of America here. Really, I think Howard Lincoln is behind a lot of this. They say we're going to go further. Any third-party that makes games for the NES in America, we're going to limit the number of games that you can make per year. We're only going to allow you to release a maximum of five games per year on the platform. They're just flagrant here. They just like, oh, the DOJ is never going to come for us.

Ben: Which they didn't, I don't think.

David: They did in Europe. I think they got in trouble for this, but somehow they escape in the US. There is truth to the promise that Nintendo is making to consumers. If you do this, it does mean that anybody who publishes for the NES can't just offload a ton of crap on the system. They have to pick their five best games, and that's all they can do any year.

Ben: If they feel like someone's game is crap, they're not going to prove it. No chips for you.

David: Exactly. The third thing that they build into the Nintendo of America licensing program, your games that you publish on the NES have to be exclusive to the NES for at least two years, which doesn't matter right now because there's no viable competition, but will become very important very soon.

Ben: Yeah. Dirty.

David: Or clean. Nintendo would say clean.

Ben: Yes, they would.

David: We're going to keep our platform clean. Nintendo of America and Nintendo of Japan finally align that they are going to launch in North America for the 1985 holiday season. They're going to launch in a test market to start the New York City metro market. It's super important because this is the epicenter of the toy industry.

They managed to get relationships with both FAO Schwarz and Toys R Us. Toys R Us would become huge. Of course, it's already national at this point, the biggest toy chain in America. It's based in New Jersey, so it's very strategic to launch in New York.

They convinced the retailers to carry them. This is where the next set of innovations come from Nintendo of America. Partially, I think this was a necessity because the retailer's, even though they know this is an incredible product, they're skeptical. It's not obvious that this is going to work. The consumers are way, way, way down on home video games at this point, even still in 1985.

Nintendo says, we will come merchandise this within your stores for you. We'll make it so easy for you to do this test with us. You don't have to take your staff off of other things if you can give us space in your stores.

Ben: How very Louis Vuitton.

David: Exactly. This is I think the first store within a store in America, literally. They come in, they set up the Nintendo displays, and they do everything. Eventually, this would evolve and become the World of Nintendo. If you were a kid or parents in the 80s and 90s and you bought Nintendo products in a toy store, you bought them at the World of Nintendo store within the Toys R Us, Target, or Babbage's or whatever, and all of that experience was controlled by Nintendo of America.

Ben: Fascinating.

David: Of course, they could put all other ancillary merchandise in there—Mario backpacks, t-shirts, blah-blah-blah, what have you.

Ben: God knows did they put Mario on backpacks and t-shirts.

David: Boy, did they ever. They managed to sell 50,000 units during the Christmas season in New York, which is not a grand slam success by any means that they even sold that much. That'd be about $5 million in total sales. Again, not a lot. But given that the whole industry had shrunk to $100 million in sales, they could sell $5 million in one metro market in one holiday season.

Ben: To take 5% of the US’ market share just in that one holiday season, that one metro, not bad. It's funny when you said 50,000, I was like, so it flopped when it launched. But actually, when you think about it, relative to how terrible the market was.

David: No. Everybody was like, look, do we wish we sold more? Sure. But this is actually a success. Throughout 1986, they start rolling out more metros throughout the US. They take a Rolling Thunder approach, which we're going to get to in a minute. It also becomes the next innovation from Nintendo of America.

Ben: Can you imagine this today, if they rolled out the Switch city by city? It's so antiquated.

David: It's so antiquated, but so brilliant, which we'll get into in a sec. They sell a million units throughout all of 1986. We're now in real business. In 1987, it's officially available nationwide. They sell 3 million units in 1987 and 10 million game packs.

At this point, they're already basically coming close to parity with Japan, which is incredible, given that the whole industry was dead two years ago in America. But the strategy and how they roll out to retail is brilliant. Remember, it was oversupply that killed the market before, and you're trying to bring a market back from the dead. What will kill a market is when you have supply and demand out of whack, where there's way more supply than demand.

Even though there's just a trickle of demand for video games at this point in America, Nintendo of America leans into it. They say to retailers after that first New York City test launch, we only have a very small amount of product available. They ration the product.

Ben: I think they fill 50% of every order.

David: This is an unofficial, never written down anywhere for fear of the DOJ. An unofficial policy of Nintendo of America for years and years and years, retailers only get half their orders. It works like a charm. All of a sudden, the NES and a video game console goes from being on the mark down collecting dust in a bin somewhere to the hot thing.

Ben: You better show up at 6:00 AM to get it on the shelf.

David: You got to stand in line. It becomes super hard to get. It's everything we talked about in the LVMH episode, this object of desire that is very difficult to get.

Ben: They also take a page out of Disney's book, and they keep most of their game catalog out of production most of the time. It's also hard to get a game unless it's new, or one of the few that they've brought back into production.

David: Yup. Yamauchi actually brings a lot of these innovations from Nintendo of America back to Japan. They alter the terms of the licensing agreements with third-parties. They go even further in Japan in true Yamauchi style. They only make three games a year in Japan instead of five games in the US. They add the exclusivity clause. Like we said, they changed the hardware on future Famicom models to add a lockout chip.

Ben: They have so much control over every player in the ecosystem.

David: It's so Disney-like. Finally in 1988, Nintendo of America still has their retail strategy, shall we say, but it blows through the roof. They sell 7 million NES units in 1988, which is way more than Japan, and 33 million game packs in America in 1988. That's just in America, a billion dollars in console revenue and another $1½ billion in software revenue.

Ben: A billion dollars in console revenue in 1988 is 10 times the entire market size for home video game consoles four years before.

David: In 1989 and 1990, they sell about another 10 million units of the hardware each year, such that by the end of 1990, 1/3 of American households, 30 million American households, have an NES. In the annual Q ratings in America, which aren't as much of a thing anymore, but I had to be reminded of it, it's the measure of recognizability of celebrities and brands in America. In 1990, Mario has a higher Q rating among American kids than Mickey Mouse. Isn't that wild?

Ben: That is wild.

David: This is where they just start running away with it.

Ben: In 1990, this is when they have 95% of the video game market in the US.

David: Yes, this is the peak. This is Nintendo at the peak of their power. The Sega Genesis, the Mega Drive in Japan, had launched in 1980 in Japan and 89 in America, but it's a flop at first. It takes them a couple of years to figure out the marketing and how to compete against Nintendo.

Nintendo is just an unabated path, firing on all cylinders. They do just these incredibly innovative things. They launch a 1-800 toll-free line for game counselors. This is incredible.

Ben: Do you know my personal story with this?

David: No.

Ben: My wife's mom worked in Redmond in the correspondence department for Nintendo, and they had two groups. One is the game counselors, and this is super hardcore. You take a test. There's a great Netflix documentary that describes it called High Score. It's got footage of a bunch of people in the game counselor group right after they take their test. They are on the phone talking people through levels and kids are calling up. My mother-in-law worked in the correspondence department.

David: The letters.

Ben: Letters. She was saying that they would get hundreds and hundreds of letters. They would answer every single one. They were almost always, to illustrate and validate the point that this was a little boy thing for a long time and teenage boy thing. She's like, basically, all the letters are from little kids, mostly little boys. They're just asking for help and thanking Nintendo for making great games. It's just this unbelievably heartwarming thing, but it also gave Nintendo such a direct relationship with customers.

David: They eventually do make the phone line, I think it's the Nintendo powerline, paid. But in the beginning, it's free. Think is crazy. They're offering game counseling advice like help with games for free. This is season 11 star experience. Not only are we going to sell you the most powerful hardware on the market by years for a really cheap price, we are then going to give you a toll-free number that you can call for free, and we will help you play the games.

Ben: They wanted to answer every single one, so they had 80 people regularly on staff. But during the holiday season, it would be 300–400 people that they would staff up to to handle all the calls.

David: This also tells you about the margins that they were making on the side.

Ben: I asked my mother-in-law about it last night as I was getting ready for the episode. She said it was a pretty amazing place to work because as you can imagine, I don't think her logic was because it was so profitable, but the fact that it was so profitable and it was such a like central part of the country's Zeitgeist, trickles into the culture, where everyone's doing well, everyone's having fun at work, the work itself is fun. It's such a family safe, clean brand that there's only upside to every interaction that you're having.

David: It's funny. This is a subsidiary of a Japanese company. It's not like anybody working there has equity in what's happening. In fact, they were all paid at or below market.

As one example of the money floating around, at one point, Nintendo of America buys a bunch of properties in Hawaii and basically creates their own internal resort for Nintendo of America employees, that you could book to go and take your family to Hawaii and stay in the Nintendo-owned properties. We'll talk about this a little bit more next time, but they buy the Seattle Mariners. Can we talk about that? This is a very profitable enterprise.

Ben: Pretty amazing perks to get to work there, you end up with free game systems, free games, and you are the cool parent.

David: This is one half of the amazingly innovative direct relationship with customers that Nintendo of America comes up with. The other half is Nintendo Power. It's crazy. Doing the research for this, there are issues of Nintendo Power that sell on eBay today for thousands of dollars. The amount of brand affinity that this creates.

Ben: So much of next episode is going to be about Pokemon, but I used to buy Nintendo Power for the maps of the Pokemon levels, to be able to show you where you need to go walk to unlock something and where different Pokemon are found. The idea that you're taking a pretty small screen—in my case, it was the Gameboy Color, but back in the Famicom days, it was still a pretty small snapshot of the world on the screen—to be able to lay it out in a magazine format to really show you do the whole thing, it helps you understand how to play the game so much better. Of course, there's editorial and of course, there are secrets that they divulge, but I think this thing built up a pretty significant readership.

David: Six million in circulation.

Ben: Crazy, right?

David: Here's what they do. Everybody who mails in the warranty card for an NES automatically gets added to the Nintendo Fun Club fan club.

Ben: They're getting all the addresses and names of every single one of their customers directly.

David: Nintendo's head of marketing, Peter Main and then Gail Tilden, who worked in the marketing department came up with all this stuff. Gail ended up running Nintendo Power. The first year of the NES in the US, they send out the Fun Club newsletter for free once a quarter to everybody who registers, and then they realized, this could be so much more.

Gail starts an actual magazine, Nintendo Power. They send in the next mailing to everybody, they say, hey, you can subscribe for $15 a year to a monthly magazine. They instantly get a million-and-a-half subscriptions. It's the fastest magazine to reach a million subscriptions circulation in the US in history, and becomes one of the largest magazines in the country. All this is amazing.

I think they eventually raised the cost to $20 a year. They get 6 million subscribers, so that's $120 million a year in high margin subscription revenue coming to Nintendo, dropping the bucket. What it's more way, way, way more valuable for, though, not just the relationship with the customers, it's for selling games.

The game previews, they use Nintendo Power to just juice all of the Nintendo first-party and some third-party games. They control the entire ecosystem now—the marketing channel to the customers, the retail experience within the stores, the hardware, the software, everything. It's one of the greatest businesses that's created of all time.

Ben: The Nintendo Power strategy reminds me so much of the NFL with NFL Films and the NFL print division.

David: Absolutely.

Ben: Not only are you doing what the NFL did, which is building hype around your media properties and around all of your intellectual property, you are going one level further, as we just talked about. You actually have a direct relationship with a customer. They built a six million-plus CRM of people who bought Nintendo that they otherwise wouldn't have had their contact information, but now they have a new way to market stuff to them.

David: Yup, it's just this incredible story.

Ben: Here's the craziest thing that I was trying to contextualize some numbers. Remember how I said in 1989, Nintendo's sales were 10 times the market bottom?

David: Yup.

Ben: That a billion dollars of revenue relative to the 100 million low point? Two years later, in 1990, Nintendo did almost $3 billion in revenue, which was the entire industry market size at its peak before the fall. Nintendo's revenue alone in 1990 is the same as the entire industry in 1983 at the height of the mania.

David: Just incredible. I don't know if it first happened that year in 1990. The only thing I read and that I know for sure is that by 1992, Nintendo's profits—not their revenue, but their profits—surpassed all of the major movie studios and television networks combined. Isn't that wild?

Ben: It's so insane. The NES, and I think it's probably about time to start tying a bow on the NES story here, would eventually sell 62 million consoles worldwide. I think we should save the Super Nintendo, Gameboy, and the whole battle with Sega, as the beginning for part two. What do you think?

David: Yes, that was my intention all along.

Ben: There's plenty of analysis to do just on part one here.

David: This is the perfect place to leave it because here we are. By the end of the NES Famicom generation, Nintendo has revived, rescued this industry from death's door, built one of the most impressive monopolies of all time in business anywhere in the world, and a global monopoly too. They can basically do no wrong. What happens next is the fall from grace. I think that's going to be the perfect place to start the next episode, how they fall and then how they come back.

Ben: Agree. It's also worth pointing out a little bit at this point. For fiscal 89, just to put some numbers around this, they did $1.84 billion in revenue and $217 million in earnings. They're doing 12%-ish net income margin, which is good, but not as good as big tech companies today. We're talking about how amazing the business model is, but it is worth pointing out just how much R&D they had, just how hard it was to manufacture a lot of this physical stuff.

At this point in 89, they were heads down on two future generations of consoles, actually three, including the Virtual Boy. There's a lot of real expense in the business, even though they're blowing the doors off sales.

David: I think that's true. I think that net income was probably suppressed and artificially low, perhaps, in part because of all the cash sloshing around that they're using, but also all the international entities. I don't have the stat at my fingertips, but I believe operating margins were more in the 30%-ish range. It's still not like tech companies today, but good.

Ben: Spinning off hundreds of millions of dollars in cash is nice.

David: Yes. There are a lot of tax efficient ways to hide those hundreds of millions of dollars.

Ben: That's a good point. Before we get to analysis, I have two very fun asides for you that are little branches off this tree of story. I'm curious if you found them because one is incredibly up your alley. Before we do that, we want to thank one of our favorite companies in the world, Tiny.

David: Long time Acquired friends and partners, Tiny, who have big, big, big news. They are going public. This is incredible. We're so happy for them.

Ben: It's funny forever. We've talked about how they're the Berkshire Hathaway of the Internet and they were missing a key ingredient, which was being a public company.

David: Now they are truly going to be the Berkshire Hathaway of the Internet. This is so cool. I've always thought one of the most amazing things about Berkshire Hathaway and one of the reasons I've been a shareholder for so long, is basically, you could get no fee, no carry access to invest in the best private equity firm of all time by buying Berkshire Hathaway stock. Now you could do the same thing with Tiny as the first and in our view, still the best internet private equity firm of all time. If you don't already know by now, they are by far the best and leading holding company of profitable internet companies.

Ben: The most important thing is we throw this word private equity around. They're not structured like a private equity firm. They don't have private equity backgrounds. I think everyone listening probably knows the story right now of Andrew starting Metalab, a nice cash flowing business, which Metalab in its own right is, (a) a great business, (b) a great design firm.

Just reinvesting the profits of one business that they founded, buying more and more and more businesses, and that just results in a completely different structure to the business and cultural ethos, than people who have only ever worked in PE raised PE funds have highly structured PE.

David: It's just like Berkshire. It's the same thing for Warren and Charlie. They don't have a fund. They're not trying to get more assets under management to get management fees. Same thing for Tiny. They are taking the cash flow from their own businesses that they own and reinvesting them in: (a) growing those businesses, and (b) buying more to add to the platform.

Ben: Yup. They really are the acquirer of choice. If you own a business that is on the Internet, a software business that's doing $5 million or more in revenue and has call it 30%-ish operating margins or the potential to quickly get there...

David: Call it Nintendo-ish operating margins.

Ben: They can be a great place to sell your business. You can reach out at hi@tiny.com. Just tell them that Ben and David sent you, and you are an Acquired listener. Especially in this current environment, where it may not make sense to stay a private company, it may not make sense to stay a venture-backed company. You may want to clean up the cap table and just go operate the business, have some upside left for you, sell the majority of it to Tiny. That could be a really great option right now.

David: Indeed. Huge congratulations to them for going public. What a milestone. By the time this episode comes out, I think it will probably be a couple of weeks away from happening, it's happening in April. They're just great folks. We're so happy for them.

Ben: Yup. All right. Thanks, Tiny. David, my two asides.

David: This is my favorite part of every episode when you try and stump me.

Ben: I think so, too. We talked about 1983 being a really crazy year for gaming. There was a company started in 1983 that was supposed to be a gaming company, that became very large, that was not a gaming company. Do you know what that is?

David: Obviously, it's not Slack because that happened later.

Ben: Obviously it's not Slack.

David: Let's see. Electronic Arts was started in 1982 by Trip Hawkins and is a gaming company, so you're not talking about that.

Ben: Yup. It might be more fair to call it a game distribution company than a game developer. Again, it didn't really happen, so it's hard to say what exactly would have been.

David: You're also not talking about Netscape, which started as, obviously, Marc Andreessen, Jim Clark of Silicon Graphics, and University of Utah fame, which started with the initial business plan of building software for the N64.

Ben: You're getting much warmer.

David: Okay. 1983.

Ben: The original company name was Control Video Corporation. It's probably not helpful.

David: Wait, I know this. This is the problem when you become a parent. If I were a couple of years younger, we wouldn't be having this stage of conversation. I already revealed, but I got to cry uncle.

Ben: I'm going to keep giving you hints because you're going to get this. It's like the Netscape story in every single way. They wanted to develop a way to internet-connect a game console, and instead became something like Netscape.

David: Have we covered it on the show?

Ben: We have, extremely early on. We did not paint it in a great light, and it is not Silicon Valley-based. It's east coast, Virginia-based.

David: Wow, I can't believe I'm still blanking on this.

Ben: I'm hoping there are listeners screaming into their AirPods right now.

David: Here's the question. How much of this are we going to cut in post production?

Ben: It is AOL.

David: Oh, my goodness.

Ben: It started as Control Video Corporation in 1983. There was one product, an online game service called GameLine for the Atari 2600. It had an amazing amount of very prescient technology—the ability to temporarily download a game, cache it locally on device, and keep track of high scores. It would work by connecting a telephone line, GameLine would eventually go through some corporate restructuring, and eventually emerged six years later as America Online.

David: Wow. I can't believe I missed that. Here's a crazy total aside. When I was in business school in Stanford, the year is 2012–2014, the AOL building in Palo Alto was still a central hub of things. StartX, the Stanford incubator that I was part of when I was there, was actually based out of the AOL building at that point in time. Isn't that wild? Even at that point in time, AOL still had its tendrils in Silicon Valley.

Ben: Wow. Okay, I've got another one. I'm just going to start telling the story.

David: Score so far, Ben, one, David, zero.

Ben: I have all the stats in front of me. I don't know if there's me, one.

David: No, this is a game. We're doing the Nintendo episode. We got to keep score.

Ben: All right, hit your buzzer when you have a guess. In 1990, right where we ended our story, a small game developer approaches Nintendo to show off that they had ported the first level of Super Mario Brothers 3.

David: Come on, that's too easy. Carmack and Romero.

Ben: This is a crazy story.

David: Do you know what id's first name was before they shortened it to id Software?

Ben: You just read the book, so this isn't fair.

David: No, actually got this. I'm sure it's in the book, but from research for this episode that I had completely forgotten.

Ben: I do not know.

David: When I looked at a video of what you were talking about—

Ben: What is it? Like, SMB3-DOS or something?

David: No, it's related to id. Its Ideas are from the Deep.

Ben: Cool.

David: What happened was John Carmack, one of these geniuses that Yamauchi was identified and talking about, had engineered, and I understand this so much better now having done the NES episode. This is why what Carmack did at id was so incredible. He had developed in software a way for generic PCs to do side-scrolling graphics like the NES.

This was incredible because the reason the NES could do this was because of the picture processing unit, the PPU that we talked all about. Regular PCs only had a CPU, they couldn't do this. Carmack creates a software that enabled it, then they famously made a demo version of Super Mario Brothers 3 for the PC and showed it to Nintendo.

Ben: We didn't talk about Super Mario Brothers 3, but that is widely held to be the best Super Mario Brothers. One was the original, two was too hard, three was widely anticipated, and then it came out and just was even better than everybody thought it could be.

David: Yeah, three was amazing. We'll link to it in the show notes. You can find a video that came out decades after the fact of the actual id demo that Carmack coded up. It was lost. I think somebody found it on an old machine at some point in time recently.

There's YouTube, you can go get a video of watching it play. It's amazing. It's so incredible what Carmack did. They have the background of the desktop, in a Window playing on a PC.

Ben: Which you still can't do, unless you're running a Nintendo emulator on your computer.

David: An emulator, yeah. I guess it was Windows 3.1 maybe at that point in time.

Ben: It was DOS-based.

David: It was DOS-based? Whatever the GUI was that they had on top of it because they'd have to have a GUI to play a game, the background wallpaper of the GUI just said, IFD, IFD, IFD, IFD, engrossed across the screen. I'm like, what the hell is IFD? And then they figured out it was Ideas from the Deep.

Ben: That's awesome. Here's how the story goes. He invents in an unbelievably genius way on this architecture, a way to do the side-scrolling Mario thing. They approached Nintendo and he's like, look at this market opportunity I've discovered for you. Can we be the developer of Nintendo's entry onto the PC, Mario on PC? Nintendo thinks about it and they say, no, because we only want Mario to be available on the NES to promote console sales, which of course is the right decision.

David: Of course.

Ben: They turned down the short-term money to promote long-term stability. But id would then go on to rip Mario out of that PC side-scroller and turn that into Commander Keen. Carmack and Romero would then of course go on to create Wolfenstein 3D, Doom, Quake. There is some alternate world where Nintendo could have said yes, and those could have been Nintendo games.

David: The alternate worlds in this episode are wild, the Atari NES, Doom by Nintendo.

Ben: The Internet being AOL on Atari devices.

David: Right. We're not going to talk about it in this episode, but Netscape being on N64, information superhighway-based technology platform.

Ben: It's crazy. All right, let's get into analysis here.

David: Let's do it. Should we start with powers as usual?

Ben: Yeah, let's do it.

David: For folks who are new to the show, as always, we run each company we analyze through Hamilton Helmer's wonderful Seven Powers framework, where he identifies seven ways by which a company can earn persistent differential profit margins versus its competitors in any given industry, AKA have power in its industry. The seven powers are counter positioning, scale economies, switching costs, network economies, process power, branding, and cornered resources. All right, let's get into it for Nintendo.

Ben: Well said. Far and above number one in my opinion to scale economies. We have done all but name it.

David: Not network economies?

Ben: It's a good question.

David: Keep going with scale economies. I agree.

Ben: The reason scale economies jumped to mind is we just keep talking about on this episode without naming it. When we talk about things like Nintendo produced the most desirable console, which all the consumers bought, which then meant that Nintendo had power over its developers, that is a pure play scale economy, that a game was worth way more on Nintendo for the NES's distribution than it was worth anywhere else. If you're a developer, it almost doesn't matter how bad the terms are with Nintendo. You have to build for Nintendo because there's more money there, because it's amortized across so many different users of the platform that it's just always worth it.

David: Okay, I totally agree with you. I think this is the number one source of power. Isn't this network economies, though? A two-sided network effect. The more users you have on your install base, the more attractive you are to the developers, the more in better 10X, 100X developers you have developing for your platform, the more likely you are to attract more users?

Ben: It's a good question. I think the scale economies when you define it, is that you can make a fixed cost investment that is more valuable to you than it is your competitors because you can spread that cost across more customers that can pay it back in a bigger way. Because you have more customers to spread it across, that fixed cost investment is more valuable to you, Nintendo, than it would be to your nearest competitor. The fact that Netflix can pay more for content because they have more people watching.

David: I think this might actually be a special case of both network and scale economies, where it's both fused together.

Ben: If Nintendo was acquiring the games, then it would be pure play scale economies, but they're not. They're convincing developers to build on their system.

David: Yes, but there is a strong component of scale economies here, too. I think you're onto something that these are linked because it's all about the hardware R&D cycle, because you have to invest an enormous fixed cost of both money for everybody now, but at first, for Nintendo's time, in developing a superior hardware platform. That is a scale economy advantage. That directly links to the network economy of, because you can have that scale economy advantage on the hardware platform, then you can get the network economy effect going of consumers and developers.

Ben: Interestingly enough, Nintendo historically hasn't done a great job of leveraging a large install base to advantage them with the next platform. We'll talk about this next episode. Their success in the N64 did not carry through to the next generation with GameCube. They were starting from zero again.

David: It started even before then. We'll talk about this a lot more in the next episode, but an incredible self-inflicted wound that Nintendo is part of killing their dominance, they didn't have backward compatibility at every early generation. The Super Nintendo was not backwards compatible with the NES, the N64 was not backwards compatible with the Super Nintendo, the GameCube was not backwards compatible with the N64. They completely whiffed on this really important lesson.

Ben: Console R&D is actually not a scale economy because you don't have the benefit of all the people that bought your old console to amortize the cost of your new console across, because you don't know how many people are going to buy the new console.

I think that's something they've woken up to with the Switch—again, foreshadowing here—to the extent where the next big console that Nintendo comes out with, is a Switch and is super Switch compatible, then they actually start entering the scale economies game, where they can make the biggest, best piece of hardware if they can get more people paying a subscription.

David: They can port their existing user base. They first are doing it with the Wii, which not coincidentally is their big comeback, that Wii could play GameCube games. We're getting ahead of ourselves.

Ben: Definitely, we are. You're right, I think there is some sort of scale economy, some network economy here, but we're both describing the same phenomenon.

David: It's interesting, I remember back from my days at GSB at Stanford, one of my favorite professors is a professor named Susan Athey, who then later would join the rover.com board with me, and I get to re-intersect with her there. A wonderful, wonderful person, incredibly smart. She was, in addition to being a professor at GSB, the chief economist at Microsoft, and a lot of her work was on Xbox in the video game industry.

Ben: That'd be such a hard spreadsheet to make to figure out.

David: Totally. Her academic specialty is network effects. Everything she did was network effects. Video game consoles and software is the textbook classic definition of the two-sided network effects. I remember reading all about it in her class. I was like, oh, this is so cool. No question to me that both network effects and scale economies are huge sources of power for Nintendo here.

Ben: Miyamoto definitely has process power.

David: Yup, and he's a cornered resource for Nintendo.

Ben: There's something that happens in his group, where they come out with an unbelievably creative game concept that I'm sure at first, much like Pixar movies. I'm sure the first cut isn't super fun, but they have a way of turning it into fun and weeding out things that aren't fun. That is absolutely process power because I bet it would be really hard for him to write it down.

David: Totally. I'm sure a lot of people listening to this know, by heart, all of the games that Miyamoto has made. For folks who don't, we mentioned a couple. He is the Beatles of video games, solely.

Ben: He's probably the best game designer to ever live.

David: No doubt about it. In fact, there's this amazing story. I think it was in the 90s. When Paul McCartney was touring in Japan, he contacted Nintendo, he wanted to meet Shigeru Miyamoto. He had such reverence for him.

All the Mario games, Mario 64 which has revolutionized the industry, the first true 3D game, Legend of Zelda: A Link to the Past on the Super Nintendo, the Ocarina of Time on N64, Breath of the Wild now for Switch.

Ben: Did he design Breath of the Wild?

David: He's the producer now on the Zelda series. There are other directors below him, but it's all his process power.

Ben: By the way, a new Breath of the Wild or they call it Tears of the Kingdom comes out next month.

David: I have a confession to make. I've never been the biggest Zelda fan. I like them. I play them. I thought Breath of the Wild was great, it's just not my total style. There are people who named their children Zelda. A lot of people named their children Zelda after the video game.

Ben: You and I both talked to some games industry people preparing for this episode. From real core gamer type people, it's amazing how much reverence they have for Breath of the Wild, where everyone just looks at it like, wow, how did they manage to pull this off, because it's not for a core-gaming audience.

David: Once again, to the point of process power, it was a similar situation at a smaller scale where open world games were dead. They'd been totally overdone, oversaturated, the market was sick of them, and here along comes Nintendo, Miyamoto, and completely re-envisions and re-energizes the genre.

Ben: Yup. Back to the powers. Is there counter positioning in the way that Nintendo created cabinet games, or maybe in the general concept of we're not about the fastest and newest?

David: Absolutely. I think there's plenty of counter positioning all throughout Nintendo history. I think there are several examples here in these chapters of the story. (1) With narrative-driven games and Donkey Kong. (2) With the Famicom and the NES relative to especially the rest of the American video game industry. It's like, we're about a small number of high quality games, not a large number of crappy games.

Ben: Yup. Again, this will show up in the next episode, not this one, but switching costs. If Nintendo had a viable competitor in the late 80s, there'll be switching costs, but there weren't. That'll show up in the Sega battle of once you pick a side, you're dug into that side at least for the next 6–7 years.

David: For the majority of the market in both America and Japan, families are only going to buy one console system that they're going to buy all their games on. There is a subset of the market that is going to buy both the Super Nintendo and the Sega Genesis, but that's a small subset.

Today, most households are going to choose between the PlayStation and the Xbox. It's interesting that Nintendo is a third alternative thing. But 100% switching costs. My God, I think Nintendo might have every single one of these powers of looking at this.

Ben: I don't think they have branding.

David: They do now with their IP.

Ben: I don't know that that's branding, though. The definition of branding is if you receive two identical objects, and you're willing to pay more money to buy from the firm with branding power.

David: Great point. IP is a cornered resource, not branding.

Ben: The reason you buy something from Nintendo is all sorts of reasons, but not because it says Nintendo. Their nearest competitor doesn't have any of the same features and capabilities that they have. It doesn't have the games, it doesn't have the same form factor in the later years. It's like that your friends don't have it, so you can't play online. There are lots of differentiation. It's not like a bank or insurance company where everybody's competing in a commoditized way, so brand really matters.

David: Two thoughts. I think Nintendo does have brand power, but I think it is the weakest of the seven that it has. It's just incredible. I think it has all seven. The brand power I think is a smaller piece of the story, its brand power around the seal of quality, and especially with parents.

In this era, if I buy my kids a Nintendo system, I can be very sure that there's not going to be excessive blood and guts, there's not going to be sexual content, and there's not going to be profanity. I think that's definitely branding because the Genesis brand is against that.

Ben: That's true. They counter position there. I guess the reason I bring it up is because it never actually comes down to branding, because there are so few competitors that they differentiate in all ways that they don't actually need to rely on branding.

You could argue maybe in the modern era, the Xbox versus PlayStation war is actually more of a branding power for one versus the other of why you would pick since they're less differentiated. But Nintendo's wildly differentiated in the IP that is on their platforms and nowhere else.

David: At a minimum, I think they score super strong on six out of seven powers during this era. The cornered resource being the IP, process power we talked about with Miyamoto, network economies and scale economies probably being chief among the switching costs for sure. Counter positioning, yes. Have we ever covered a company like this?

Ben: No, I don't think so.

David: I don't think so either. It reflects on what happened. They had 95% global market share in this enormous industry.

Ben: And perfect timing. All right, playbook. We've talked about a lot of these, so I don't want to just revisit some. I want to bring up some that I think are new. Mario as a character, and I pulled this out of the Super Mario book from going deep on that franchise, is so perfect because he's so universal. It's story-driven, but there's not that much personality, so anybody can see themselves in Mario. Whereas if you're playing more of a core game or even an RPG of any sort, you'll experience a story that's unfolding before you as an observer.

David: It's like reading a book.

Ben: Right. But in Mario, there's not enough depth to Mario to say, I'm observing Mario. You just are Mario. That's the perfect casual gaming character to just massively expand the gaming audience beyond teenage boys and make it the most accessible ever.

David: Yup, completely agree. It's also interesting to note, though, during this era too, and again just to how powerful Nintendo was as a platform, they also had all of the great opposite kinds of games, the Dragon Quests, the Final Fantasies, the hardcore story-driven RPGs.

Ben: Mario is also fun every time. You don't get sick of the music. The levels were easy to play, but hard to master. Most of the levels only had small tweaks between that stage and the next stage, but somehow it still felt fresh and new every time, especially in this era where a lot of the competitors' games, you'd quickly tire of them. You could play Mario for 150 hours and it would still feel fresh and new every time. That's an extremely difficult thing. That is why Miyamoto is such a genius.

David: He does this genius thing of incredible world building, especially starting with Super Mario Brothers of you're in the Mushroom Kingdom and it's this incredible fantasy world. But it's story-driven, not narrative-driven. You can create your own narrative within the world.

Ben: Right. It's funny that the Popeye IP stuff didn't work out. It was their first choice to use Popeye IP. But by not getting it, they ended up creating this unbelievably valuable franchise with Mario. I pulled some numbers. You mentioned 385 million Super Mario games were sold cumulatively. That gets beat by Tetris, Pokemon, Call of Duty, and GTA, in terms of total franchise copies sold ever.

But Mario, if you pop up a level and include Mario Kart and Mario Party, that's 826 million copies of Mario games sold, which definitely makes it the best selling franchise of all time. It's so valuable. In fact, Nintendo leaned into this.

This is another clever thing. They did not allow licensing of other characters. If you wanted to license a Nintendo character for a backpack, lunchbox, or one of the other 10,000 things people have licensed Nintendo IP for, for the longest time, they would only grant you a Mario license because they wanted to build a mascot. They wanted to build so much IP and brand value into the Mario character that he became Mickey Mouse.

David: Interesting. They concentrated the effort, as opposed to having Kirby licenses, Link licenses, or Zelda licenses.

Ben: Right. It's interesting what that allowed them to do because it made Mario more than a plumber. It made it so that when Mario appears in other games, it doesn't feel strange because Mario just means Nintendo. It doesn't mean side-scrolling plumber character, which was another clever creative decision, where he's just like, oh, he's the Nintendo mascot. Sure he's got a game of his own, but he shows up in all these places. It keeps going back to like, it's important for him to not have that much character depth because it makes it so that he can be super universal as the mascot.

David: Great point.

Ben: There's one more in this train of thought, and this will be I think a big theme of the next episode. The fact that Nintendo platforms are first and foremost for Nintendo IP. They love making high margin revenue on other developers. They're going to say no to a lot of developers because they're inappropriate for the platform, they don't deem it a good game, or whatever other finicky belief that they have that it's not Nintendo in some way.

Unlike other platforms, where they have a launch title and a mascot for the platform that's just to juice the initial sales of the platform so that they get a network effect, and then they can really make money from the third party developers, Nintendo has such good, owned IP that I think they would be delighted just making the NES, SNES, the Gameboy, and it's only ever their games on it.

The way that that has compounded over all these years is that they own some of the most differentiated IP in the entire world and basically the only globally recognizable video game IP in the entire world. In second place is Pokemon and they own a third of that. I think it was probably accidental at first, but then once they realized the value of what they had, they were super protective of it.

David: Yup. With Pokemon, too—we can talk about this more next time—they only own a third of the IP, but they own Pokemon only being on Nintendo platforms, to your point.

Ben: Correct. It's very Bernard Arnault, it's control more so than economics. All right, what do you got?

David: The one big playbook theme that I want to talk about, Peter Main, who we mentioned, was Nintendo of America's VP of marketing. He, along with Gail Tilden and others were really responsible for the core of the innovation that came from the American side of the business. He codified what ultimately became the company's unofficial slogan, besides do everything to be a monopoly without using the word monopoly. We'll put that aside for a minute.

The phrase he comes up with is, "The name of the game is the game." I think this is such a key to understanding Nintendo and so applicable elsewhere. Specifically, I think all great personal and corporate encapsulations are both 100% true and 100% ridiculous and not true.

What he means and what Nintendo means by it is that the quality of the games that we make and that others make for the platform, is the name of the game. That is all that matters. The quality of the product, the quality of the games, if we make and make available exclusively the very best games out there on our platform, we will win. That's 100% true.

That is what matters, and that's part of Yamauchi's true genius as a complete outsider recognizing that the Shigeru Miyamotos, the Gunpei Yokois, are the key to making all this work.

At the same time, though, the reason it's utterly ridiculous and doubly ridiculous, because Peter Main coins it, he does everything besides make the games. That is so important, too. It really comes down to product and distribution. Both are really important.

Ben: Also, the best CMO’s party line is, ‘our product is just so amazing, it sells itself.’ That's exactly what you hear there.

David: I think Nintendo is such a perfect case study of this dichotomy and they're both so true. Nintendo has the best products, the best IP, the best games. They also, especially in this era, had the best distribution channels, the best relationships with their customers, the best control over their ecosystem.

Ben: The best strategy, generally.

David: The best strategy, right. When you can marry both of those, that's when you get 95% global market share.

Ben: This was my final question in the playbook themes that I had written down that I wanted to pose to you. What other businesses ever have had 95% market share? Or maybe the interesting one might be like, what businesses today? This isn't a narrowly-scoped market. This 95% represents global video games. It's not browser market share on iOS devices or something like that. It's global video games.

David: The only one that immediately comes to mind is I think Apple and iOS, not of revenue but of profits, have something on the order of that global market share of smartphone profits.

Ben: Smartphone profits, yup. The other one that's close, but I think is more around 85%-90% is US-based search engine usage.

David: I guess at a certain point, Facebook had something like that of social networking across all of their family of products.

Ben: The day before Instagram launched.

David: The day they acquired Instagram.

Ben: Yeah, that's true.

David: And WhatsApp during that heyday.

Ben: The most interesting thing is all the examples we're naming are under heavy regulatory review and pressure. Another one that I was going to raise is Microsoft's share of the operating system market. That probably was something like 95% also.

David: Or Microsoft Office too.

Ben: Every single one of these have gone under significant DOJ concerns, and Nintendo never seems to. Is it because people viewed this as a toy market that was not terribly important to our economy? It is a much smaller market. In 1990, they were only doing $3 billion in revenue. It's not like these companies that are doing $100 billion in revenue.

David: I think there's this really weird dynamic with Nintendo, which is why I'm so happy we're doing this episode, that it's just overlooked and underappreciated as a business story, partially for the reasons you're saying. Partially because it's a Japanese company, so there's this weird bicultural thing.

Ben: The belief that it's so hits driven makes people think like, oh, well, whatever market share they've accumulated surely isn't durable.

David: There are such great books, as we said at the top of the episode out there, and documentaries on Nintendo. There are ones from a business perspective, but nobody's covering Nintendo like people are covering Apple.

Ben: No. Everyone's covering Nintendo for the nostalgia of the character development and the fan service.

David: Yeah, the business story is just as good.

Ben: All right. I, even though we killed it, want to do grading on this episode. I'm curious if you're game. I think bear and bull is stupid since we know the history from 1990–2023, so let's actually grade.

David: That would be really interesting to do if we could go back in time and not know what happened next. But obviously, we can't do that.

Ben: That's true. Would we think that Nintendo was going to take over the world and expand beyond gaming?

David: Probably.

Ben: Would we think that gaming would go from a $3 billion market to $120–$150 billion market now? That would have been a tough prediction to make.

David: I bet we would think what Jim Clark and Marc Andreessen thought, which is that Nintendo is going to become the computer.

Ben: The window to the Internet. Yeah.

David: We would not at all have predicted that just gaming itself was the thing and would become a $150 billion market. We would have said it'd be a $150 billion market of something else.

Ben: That's a good point because you're out on a limb if you try to make the prediction in 1990, that gaming becomes a $150 billion market.

David: Totally.

Ben: But it's a nice little hedge to be like, oh, I totally think Nintendo could address a $150 billion opportunity, but it'll be a bunch of stuff. It's almost like all the people in 2016. When asked about crypto, they were like, oh, I'm not so sure about Bitcoin, but I think the blockchain is going to be a fundamental technology. It's the way to hedge and you're like, I don't know exactly what the AI use cases are yet, but I'm sure it's going to be huge.

David: Yup. Okay, that was fun.

Ben: What would have happened otherwise? Yeah.

David: Okay, grading.

Ben: I suppose the interesting thing is to take it from a shareholder perspective in, call it the late 60s-early 70s through 1990. Let's just say the 20 year span from 70 to 90. How do you feel about Nintendo relative to being a shareholder of anything else?

It is hard, especially because of all the exchange rates and the changing inflation in Japan, inflation in the US, and all these decades that have happened since then. It seems like the market cap in 1990 of Nintendo is in the $15-ish billion category, which by today's standards, of course, seems quite small. We're like, $15 billion companies are inconsequential and stacked up against big tech.

David: But was huge back then, especially because there was all this weirdness of having to buy a Japanese-listed company and most of the global capital markets are not based in Japan.

Ben: Right. One question I did have is, in your notes, do you have in the 70s, any revenue figure? Because we know that it was around $3 billion in 1990.

David: I do not. I imagine it was inconsequential compared to what it would become.

Ben: The framing is it rounds to zero and then 20 years later, it goes to $3 billion in revenue, $15 billion in market cap. From a market addressability perspective, it's interesting that what happened is they had literally perfect timing to enter a market that would become a $100+ billion market, and they went in and they captured 95% of it.

What I should be saying to you is, this is an A+, no question. They couldn't be positioned any better, they couldn't have executed it any better, they own the customer relationships, they own all the IP, and they have immaculate control over the whole thing. I was thinking about it. The reason I don't think it isn't A+ is because of the fall that will happen at the beginning of the next episode, which is they blew a lead, where they were up by 10 runs in the bottom of the 9th.

Maybe the technology wasn't available at the time to have further lock-in, but it does feel like if the gaming industry was going to grow from $3 billion to $100+ billion over 30 years, it's amazing that Nintendo didn't manage to serve on top of that wave, but ended up getting clobbered by it two or three more times before figuring out how to really find their place there.

David: Yeah, and I think had some really unforced own goal errors there along the way. Nintendo very much could have embraced backward compatibility, their console cycles. Nintendo very much could have embraced the CD format and failed spectacularly, or both of those.

Ben: I guess I'm an A. I would be an A+ but for the fact that we do know the future, and we do know that they weren't as positioned as well as the numbers would state. I think that's why it's hard to be an investor and specifically hard to be a public company investor. The numbers can tell you one story, but then there are either execution problems in the form of unforced errors, black swan events, or the world changes in ways that you absolutely could not have predicted by just looking at numbers.

David: It's so hard. I'm absolutely inclined to agree with you, given that we know what happens next. On the other hand, if you purely scope it to this period of time, these guys executed 10 out of 10 during the 1970–1990.

Ben: Complete masterclass in business strategy and execution.

David: Like we were saying earlier, we've never covered a company that scored so high on so many of the powers.

Ben: All right, give me your grade, David.

David: I hear your argument. I love it. That's the reason we're doing the second episode, but I'm going to give them an A+ for 1970–1990.

Ben: There you have it.

David: There we are. Carve-outs?

Ben: Carve-outs. By the time this episode comes out, the Oscars will have happened, so you will know if this already is best picture or not. But even if it is not, Everything, Everywhere, All at Once was exceptional, and I highly recommend it.

David: Oh, yeah. You've told me before that that was amazing.

Ben: Really good. Have I recommended it on the show, my double carve-outing?

David: I can't remember. I know you've told me about it. It's hard to separate our conversations on the show and not on the show.

Ben: It's a great couples movie, but it's also a great indie film. It's a feel-good movie to watch together. I also recommend watching it alone because I think it's just a great piece of independent filmmaking. It is unbelievably VFX-heavy, which you don't expect from the first 20 minutes. You're going to start watching this movie and be like, what do you mean that this is unbelievably VFX-heavy?

It was done by a four-person team. It's a completely different take on VFX. It's not like Avatar: The Way of Water, let's go spend $250 million to create a film. I think it's a $25 million total budget, where it's almost like, let's show off how amazing After Effects and other state-of-the-art software that can run on your computer have gotten.

David: Did they use Unreal Engine to do some of it?

Ben: I imagine. I'm not sure. I got to watch more YouTube videos like behind the scenes.

David: Which is funny. We spent a lot of time on this episode. Of course, the natural comparison is video games versus music and movies, but it's all converging.

Ben: There is a key difference with video games, which you pointed out earlier, which is, it is a different part of your brain in terms of am I experiencing the media, is it coming at me passively, or do I have to be active in the media?

David: Yeah, totally agree. I think there will always be separate industries, but the tools and the technology are converging. My carve-outs are two related ones, Michael Lewis interviews. For whatever reason, on the kick of listening to Michael Lewis—and I just love Michael Lewis so much—and I went back and I listened to, I think either you or I before had as a carve-out, his interview with Tim Ferriss a couple of years ago, which is so great.

That got me on a kick of seeing what else is out there. Everybody does his quiver of stories that he pulls out. You listen to a few and you're like, okay, I've heard you talk about this 16 times.

I found one that I'm so glad I did, deep cut on YouTube. It's a three-hour interview on C-SPAN on Book TV. I think it's even on C-SPAN 2. I have no idea why Michael did this. It's from a couple of years ago. It's by far the longest one out there. He goes three clicks deeper on everything. It was just fascinating to hear all the real deep cut Michael Lewis stories.

Ben: I thought I'd listen to all of his interviews, so I can't wait to listen.

David: I've got YouTube Premium which is amazing. I've been listening to it in podcast form without the video while I go and run some blocks and stuff.

Ben: It's the only way to live.

David: Only way to live. I can't believe I went so many years without YouTube Premium.

Ben: What is it, $10 a month? It's a pretty easy $10 a month.

David: Literally, you're valuing your time. If you don't pay for YouTube Premium and you watch any amount of YouTube, you're saying that my time on all these ads is worth zero.

Ben: If they were better ads, I'd be more inclined to pay attention.

David: Right. It's not like these high quality brand, Acquired-style ads where you want to hear about YouTube ads or YouTube ads.

Ben: It's like, oh, Sprite. I guess I do drink Sprite. Never mind that I haven't drank a sugar soda in 15 years, but sure, show me another Sprite ad.

David: Right.

Ben: All right. Anyway, listeners, we'll give you the rest of your fifth hour back, fourth hour back, whatever it is. Thank you for coming on the journey with us. Our huge thanks to Pilot, Tiny, and Vanta. You can click the link in the show notes to learn more. You can join the revamped, reinvigorated Acquired LP program and become a limited partner.

David: Since we're at the end of the episode. I thought about doing this earlier, but I thought, let's just get right into Nintendo. But now that we're at the end, I can say the inspiration for how we've revamped the Acquired LP program where one of the core things we want to do is involve LPs in the audience and helping us choose topics that we cover on the show, was inspired by my favorite video game podcast which does this.

The great folks over at Resonant Arc are a video game book club podcast. They play video games like a book club and they choose a game to cover. The key benefit of being their Patreon is you can vote on the next game that they cover. I was like, that's brilliant. We should do that on Acquired.

Ben: It is brilliant. LPs, I would say maybe a week after this episode comes out, keep an eye out for an email pulling you. David and I have a short list of the next episode that we will do. We're curious to hear your feedback. We'll put a free-form field in there, too.

Also, we're starting back up with the Zoom calls. If you want to hang out with David and I on Zoom for an hour, keep an eye out for an email on that, too. If you are an LP, acquired.fm/lp to join.

Go check out ACQ2. We have, seriously, the best content that we've had on that feed in a long time coming up. I've been really pumped with the last few episodes and chock full of it even more. Search ACQ2 in the podcast player of your choice. No space. I know we may change that, but as of right now, no space just like ESPN2, our muse. We're pumped to launch that. Join the Slack, almost 15,000 folks strong.

David: We just passed 15,000.

Ben: 15,000, then I got to update my script. Smart, thoughtful people, talk about this episode. Get some merch, acquired.fm/store. We have lots of things, David. We're a small media empire.

David: The Acquired Slack is like our version of Nintendo Power and the Power Line.

Ben: There we go. We need to produce a Nintendo Power. All right, I'm cutting this off. Listeners, thank you. We'll see you next time.

David: We'll see you next time.

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