Good Money After Bad: Why Government Should Not Fund Private Businesses
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Curt Schilling is a hero to Boston sports fans. In 2004, at the relatively advanced age of 38, he valiantly pitched and won two critical post-season games while suffering from an ankle injury so severe that his sock was soaked with blood, propelling the Red Sox to its first World Series championship in 86 years. But Schilling’s career outside of baseball, especially since his retirement in 2008, has been less than stellar.

In 2006 Schilling founded a company, Green Monster Games – subsequently renamed 38 Studios – to develop and market MMORPGs – Massively Multiplayer Online Role Playing Games – for which he has a longstanding passion. Earlier this week, barely three months after release of its first product, 38 Studios laid off all of its 400-odd employees and closed its doors for good. How and why this happened is a cautionary tale for those who think it a proper function of government to provide financing to private companies.

38 Studios seemed to have everything going for it: a prominent public face and some of the best management, marketing, and technical staff money could buy. Schilling, who earned around $114 million during his career as a baseball player, put about $30 million of his own money into the venture. The company had leased 30,000 square feet of space in the historic Clock Tower business park in Maynard, a Boston suburb. The Clock Tower, which began life in the 19th century as the world’s largest woolen mill, had previously housed another famous start-up, Digital Equipment Corporation.

But all was not well. In 2010, needing additional funding to stay afloat until it could launch its first product, the company negotiated a $75 million loan guarantee with the government of neighboring Rhode Island, which agreed to a special issue of “moral obligation bonds” to raise the funds. Moral obligation bonds carry an implicit, but not a binding, commitment by the issuer to pay bondholders if the beneficiary defaults. Schilling then turned to the Massachusetts government to see if it would go Rhode Island one better, and Massachusetts, saying it would not get into a bidding war, turned him down. So in 2011 the company moved its entire operation to Providence, Rhode Island.

38 Studios finally launched its first product, a sword and sorcery fantasy game called Kingdoms of Amalur: Reckoning, a single-player game, in February 2012, while also announcing that a second offering, a multi-player game dubbed Copernicus, was in an advanced stage of development. Kingdoms of Amalur: Reckoning sold well – over 1 million copies at $60 a pop – but it was not the blockbuster hit the company needed. In early May, 38 Studios missed a $1.1 million loan payment. On May 17 it sent a check to the state government, which bounced, though the next day it made the payment via a $1 million wire transfer plus a personal check for $100,000 from an unnamed source. That same week, the company failed to meet its payroll obligations. On May 24, 38 Studios laid off its entire work force.

This sorry history can serve as what we might call a “teachable moment.” First, celebrities are not necessarily good businessmen. For every Magic Johnson, who has become a very successful and widely admired real estate investor and property developer, there are a dozen celebrities like Lenny Dykstra, the former Mets baseball star, now bankrupt and serving a three-year prison sentence for fraudulent business dealings, or like Curt Schilling, who committed no crimes but whose talent on the field failed to translate into success off the field.

A second, and perhaps more important, lesson, is that government officials should not play at being venture capitalists. The one question Rhode Island’s Governor, Donald Carcieri, and the senior staff of the Rhode Island Economic Development Corporation should have asked but didn’t, is why Schilling’s company couldn’t raise the money it needed from real venture capitalists. It wasn’t for lack of trying.

Before turning to the Rhode Island state government, Schilling had approached several Boston venture capitalists, who turned him down flat. According to the Boston Globe, this was largely because, though a video game enthusiast, Schilling had no experience developing one and no relevant business experience. There was a widespread impression among venture capitalists that an investment in Schilling’s company “would require a lot of babysitting.” Also, Schilling was asking for $48 million, a huge amount for first-round financing of a startup with no revenue, and was unwilling to give up much stock in exchange. The venture capitalists, moreover, realized that $48 million would not be enough. The cost to develop a massively multiplayer game is huge, and Schilling himself estimated that he might need an additional $100 million to finish development of Copernicus.

The Carcieri administration was dazzled by Schilling’s celebrity – how cool is it, after all, to hang out with famous athletes –and saw in his request the chance to develop a new, high tech sector to replace Rhode Island’s declining jewelry manufacturing industry.

In the event, the deal very nearly blew the state’s entire $125 million allocation for business loan guarantees on this one project and left state taxpayers on the hook for as much as $112 million in principal and accrued interest.

In so doing, the state violated one of the most fundamental precepts of venture investing, which is that you don’t put all your money into one company, since most investments either underperform or fail outright. By most estimates, 20 to 30 percent of venture-backed companies will fail outright, and another fifty or 60 percent will underperform, merely repaying the investment or making a small return. What saves the venture capitalists from ruin is the one massive success – maybe one in ten investments for a successful firm – that pays for the failures many times over.

Some venture capital firms, such as Kleiner Perkins Caulfield & Byer, can point to a dazzling string of successful investments, which include Google, Netscape, Amazon, Twitter, Genentech, and Intuit. But even Kleiner Perkins has invested in its share of duds, companies like Segway, which despite receiving investments of more than $150 million has yet to make a profit, or Friendster, an early social networking company now all but defunct. The average VC firm is barely profitable, and when you factor in management fees, most of them lose money for their investors. According to Cambridge Associates, a research firm, the return on venture capital over the past decade has been -4.8%, as compared to -0.4% for the S&P 500.

If people whose sole business it is to pick winning companies to invest in aren’t terribly good at it, it should come as no surprise that public officials are even worse. In the current social and political climate, in which entrepreneurs get the same kind of adulation as rock stars and government is derided as the source of all our problems, it is understandable that public servants and politicians would want to play at being swashbuckling capitalists. It’s a role that ill suits them. There has so far been no suggestion that corruption was a factor in the 38 Studios debacle, even though Rhode Island is notorious as one of the most corrupt states in the country. On balance, however, corrupt politicians have probably cost the state – and the entire country – less than incompetent ones trying to do a job for which they are spectacularly unqualified.

Posted 06-01-2012 3:55 PM by Charles Krakoff