SAN FRANCISCO (04/05/2000) - If you play with him online, Sega Corp.'s Sonic the Hedgehog might give it all away. Almost. In a landmark decision by a videogame console company, Sega plans to create a new company.

Sega.com will try to grow the relatively small online gaming market by giving away its Dreamcast game machine and a free keyboard to people who agree to pay $21.95 per month for Net access for two years. The new company's initial funding, $100 million in seed capital, will come from its Japan-based parent company, Sega Enterprises, and from CSK, among others. Initially, the company will have 120 employees. Sega is hoping its decision to get the Net would spur Dreamcast customers to shuck their Internet service providers in favor of the game company.

Sega.com will offer modem access through GTE. The advantage, say Sega.com executives, is that gamers will have a "millisecond edge" over people using other networks. Sega games will be tuned to run faster over GTE servers.

Sega.com's new customers will be able to use the ISP over their PCs, but only the company's Dreamcast games will work on the network. About 12 online games will be offered by the fall, including hot titles like Quake III Arena, NFL 2K and Half Life.

It launched its first online game, Chu Chu Rocket last month. In addition to games, the service will offer limited Web access, e-mail and chat. "Consoles as an island is a dead concept," says Charles Bellfield, director of marketing at Sega of America, the American subsidiary of the Japan-based Sega Enterprises.

"I want to compete with players across the street, across town, around the world." By launching the company, Sega hopes to put some distance between itself and rivals Sony, Nintendo and now Microsoft in the race to dominate online gaming.

Online gaming will account for only about 2 percent of the estimated $7 billion market for electronic entertainment this year, but Forrester Research expects that share to balloon to 24 percent by 2002. Sony plans to launch its own next-generation system, PlayStation 2, in Europe and North America this fall.

In March, it launched the system in Japan. Sony's system does not come with a built-in modem. Instead, it comes with an Ethernet port that lets third-party companies develop modems if they so choose. Sony has set its sights beyond narrowband access; it's already preparing for broadband. Microsoft will omit modems from its consoles, too. Nintendo, which has delayed its next-generation launch until next year, has remained mum on what that launch will look like.

Although Sega is ripping a page from the free-PC playbook, its Net-minded business model might create a maelstrom of problems. The market has been slow to embrace the concept of free PCs, which lock consumers into restrictive multi-year contracts and sketchy customer service. Moreover, few free-PC companies have been able to meet the rush of orders from consumers clamoring for cheap hardware. Unlike companies such as Free PC, Sega argues that it will be able to meet the manufacturing demands of the new business model. In addition to selling subscriptions, the new company plans to generate revenues from advertising, sponsorship and e-commerce sales. Sega.com will need to sell between 150,000 and 200,000 subscriptions to break even, says Sega.com President and CEO Brad Huang. But the company is much more ambitious than that.

"We want to create the online destination for gamers," Huang says. Huang, 25, a former hedge-fund manager and founder of Lotus Capital Management, originally pitched the idea to Sega last year. Prior to joining Sega, Huang worked in the investment banking division of Goldman Sachs in New York, where he handled IPOs and was head of research at Credit Suisse in Tokyo. Huang's financial background might have played into the decision to hire him. Sega.com is planning an initial public offering in the coming months.