Fallen kingdom: 38 Studios' collapse and the pitfalls of using public money to support tech companies

In a career filled with many clutch throws from the baseball mound, former Boston Red Sox ace Curt Schilling's main calling card was a gutsy post-season performance made even more memorable by a blood-soaked sock. It was a pitch made by Schilling outside of Major League Baseball, however, that would prove to be his most daring one yet.

In 2010, Schilling convinced Rhode Island officials to give his video game company, 38 Studios, a $75 million loan guarantee. A self-professed fan of massively multiplayer online role-playing games (MMORPG), Schilling's dream was to create a worthy competitor to Blizzard's MMORPG juggernaut, World of Warcraft. In 2006, Schilling started Green Monster Games, which was later renamed 38 Studios. Luring the company away from Massachusetts was supposed to bring in more than 400 jobs and serve as the linchpin for launching a new tech-based industry in Rhode Island. Instead, the state's taxpayers found themselves left at the table with a multimillion-dollar tab.

Like the vaunted New York Yankees team that Schilling helped slay during his memorable "bloody sock" performance, 38 Studios suffered an epic collapse. With its ambitious Project Copernicus MMORPG still in the works, the company was unable to generate enough revenue to pay for its expenses and quickly burned through $50 million acquired from the Rhode Island deal. It then defaulted on a $1.1 million payment due in May to the Rhode Island Economic Development Corporation, which triggered a showdown with Gov. Lincoln Chafee. Besides losing access to the remaining funds from the Rhode Island deal, the company's very public drama also spooked potential investors. Tapped out financially and left with no extra lives, 38 Studios filed for Chapter 7 bankruptcy in June. Just a couple of years after its landmark deal , the high-flying developer behind the well-received Kingdoms of Amalur: Reckoning suddenly became the poster boy for what could go horribly wrong when public money is used to support private companies. The studio's high-profile fall from grace also showed the inherent risks that come with dabbling in the tech sector, said Thomas Cafcas, research analyst for national policy resource center Good Jobs First.

"The tech industry comes with its own number of tricky issues and it's important for any public entity looking to invest in it to really know the sector and what it's getting into," Cafcas said. "It doesn't make sense to get a bunch of money out the door and just go after any deal because it happens to be in tech. You need to do some really good research on how that sector works."

High Stakes

Rhode Island's buyer's remorse with 38 Studios comes at a time when more and more states are creating programs that use public funds to invest in private companies. The Lone Star State went big on public-private partnerships in 2003 when it created the Texas Enterprise Fund. Since its inception, the program has allocated nearly $470 million to private companies. Nevada lawmakers got into the act last year with the creation of the $10 million Catalyst Fund for businesses.

Meanwhile, the emergence of powerhouses such as Google and Apple made companies with a tech pedigree especially prized by states looking to boost their economic chops. In 2005, the Texas Legislature took its bet on private enterprise a step further and created the Emerging Technology Fund. Designed to bring research talent to the state and create new companies by commercializing new technologies, the fund invested more than $169 million in 133 high-tech firms by 2011. Utah has also gotten into the act, creating a similar initiative known as the Utah Science Technology and Research, or USTAR, program in 2006.

Nevada -- which is trying to diversify an economy heavily geared toward gambling, tourism and construction -- is currently trying to kickstart its own tech commercialization efforts through its new Knowledge Fund. The state is also working to free up extra capital for private equity with the launch of the Nevada Capital Investment Corporation, or NCIC Fund. The program can tap up to $50 million from the state's Permanent School Fund endowment to invest in startups and other private ventures.

The rise in these programs shows how high the stakes are in what has always been a competitive arena, said Steve Hill, director of the Nevada Governor's Office of Economic Development. In Nevada's case, Hill said the new programs are essential in ensuring the state does not get left behind by states with deeper pockets when it comes to attracting companies or creating new ventures.

"If you look at some of the states we're going up against, they're more than willing to provide money up front to attract private enterprise," Hill said. "These funds allow Nevada to compete."

A Capital Issue

The increase in public-private programs was welcomed by people such as Dave Archer, president and CEO of Nevada's Center for Entrepreneurship and Technology. Cultivating startups can be especially tough in states like Nevada, which doesn't have the same resources or easy access to venture capital that places such as California or New York do, Archer said.

"The Catalyst Fund and the NCIC Fund are two of the best things that have happened in Nevada in the time that I've been here," he said. "The biggest challenge facing Nevada is that we have very little in the way of risk capital. Our funding capacity is only a fraction of what our actual funding needs are."

Meanwhile, most of the limited venture money available in the area tends to be in the hands of investors who lack familiarity with the tech sector, said Colin Loretz, co-founder and CEO of Web-based startup Cloudsnap. Loretz -- whose company recently received support from startup accelerator TechStars -- ended up going out of state to secure funding from investors in San Antonio and San Francisco.

"What we've always found was that there were few funding options in Reno, and most of them didn't understand what we were doing," Loretz said. "They were very, very knowledgeable in more traditional areas such as manufacturing, mining and clean energy, but not cloud services."

Access to capital became an even bigger issue after the global financial crisis. The near-meltdown of the financial sector led to stricter lending guidelines and curtailed the amount of investment money available for supporting startups.

When Relina Shirley was starting HIDEit Mounts in Southern California with her husband in 2008, she tried to get a small-business loan from a local bank. Shirley was told that her business wasn't established enough to even be considered for a loan, particularly given the conditions in the market.

The lack of private capital led Shirley and her husband to self-fund their business, which makes cases for video game consoles and media boxes that can be installed behind wall-mounted flat-screen televisions.

The Shirleys managed to slowly grow their business on the internet and recently inked a deal with retailer Micro Center to carry their products in about 30 locations. The volume needed to supply those locations also happens to be the maximum amount that the Shirleys can produce through self-funding.

"The deal with Micro Center actually meant that we also had to invest in retail packaging, and that's no small expense for us," Shirley said. "We're at that pivotal point now where injecting our own cash into the business is no longer enough if we want to really grow it further. It would be fantastic if there were funding sources out there that we could access more easily right now."

Playing With Fire

Not everyone, however, is supportive of using public money for private enterprise. Paul Lenart, a member of the Occupy Reno movement, eyed Nevada's new funds with a healthy dose of skepticism. Lenart cited the greed and highly dubious ethics displayed by those in the private sector just prior to the crash of the US housing market and the global financial crisis as reasons why he's leery about giving public money to private companies.

"I don't expect the dog not to be a dog," Lenart said. "All I can say is: you better have a leash handy."

Controversies involving private use of public funds in several states back some of the concerns raised about such programs. Both the Texas Enterprise Fund and Emerging Technology Fund have been criticized for awarding money to companies that have links to Gov. Rick Perry and his campaign donors.

North Carolina, which approved a $280 million incentive package from state and local governments in 2004 to woo Dell and convince the company to build a plant near Winston-Salem, saw its officials seething five years later after the company decided to close the facility. The closure led to the loss of 905 jobs.

Another issue involves jobs that don't match the high-paying positions officials expect a technology company to produce. Cloudsnap's Loretz, for example, said that good engineers can earn around $125,000 or so per year depending on their skills and the school or company they come from. The prospect of keeping high-paying jobs was likely a key reason why Washington, D.C., officials offered up more than $30 million in subsidies to LivingSocial to convince it to stay in the area, said Good Jobs First's Cafcas.

"LivingSocial began as a tech startup in D.C. and basically said it was going to move away if it didn't get some sort of incentive," Cafcas said. "If you look closely, however, the majority of the jobs for this high-tech company aren't so high-tech at all. They weren't engineers or IT people -- they were marketing people who cold-call companies to try and get LivingSocial deals."

In the case of Nevada's new programs, some critics decry the fact that the Catalyst Fund is being distributed through local entities to sidestep a law in the state constitution that prohibits giving public money to private companies. Catalyst Fund recipients are also kept anonymous.

"Public scrutiny is the only regulator of private vice," said Occupy Reno's Lenart. "The fact that they're doing this through loopholes just underlines the underhanded BS of this program. We set up that rule (in the Nevada Constitution) for a reason, and having them go around it while using public money is another way to suck money from people and give it to business."

Lessons Learned

Despite the problems arising in Rhode Island and other states that use public funds for private enterprise, supporters of such ventures point to programs that have seen success. Researchers tied to Utah's USTAR initiative, for example, have brought in $135 million in grants to the state.

"That's significant because studies show that every $1 million in research funding the state brings in is worth 20 jobs," said USTAR spokesman Michael O'Malley. "We just had our five-year checkup, and the program is well-ahead on all the key metrics we measure with the exception of licensing revenue."

O'Malley added that the program has also made 136 intellectual property filings and contributed $81 million to Utah's state gross product.

Meanwhile, Nevada officials said they have learned from the problems experienced by other states and built the necessary protections into their programs. Management of the NCIC fund, for example, will be overseen by a private equity firm, said Nevada State Treasurer Kate Marshall. In addition to handing the reins to a firm with private sector experience and a legal fiduciary obligation to maximize returns, the arrangement also prevents the pay-to-play issues that plagued other public-private programs. Other safeguards include capping management fees and how much money can be invested in one firm, Marshall said.

"As soon as we decided to have a geographically specified investment fund, we were careful about learning lessons from other states and pension funds," Marshall said. "One was to de-politicize this so you don't have an elected official directing money to be invested in his uncle's hotdog stand."

For the Catalyst Fund, the state requires companies to meet certain objectives before any money can be released. Examples include the creation of a certain number of jobs first, said Mike Kazmierski, president and CEO of the Economic Development Authority of Western Nevada.

"We don't ever want to be in a position where we have to claw back anything, so we require the companies to perform first," Kazmierski said. "Once they achieve results, then we can reimburse them."

Risk vs. reward

There are times, however, when even performance-based incentives are not enough to prevent problems. Rhode Island, for example, also required 38 Studios to create a certain number of jobs before it could access the funds tied to the state's loan guarantee program. The company ended up hiring more employees to meet the requirement, but bankruptcy filings would later show that the company was already having financial difficulties even as it was hiring more staff. The Rhode Island Economic Development Corp., the group that set up the 38 Studios deal for the state, declined to comment for this article.

Because the Rhode Island loan guarantee is backed by "moral obligation" bonds, the state can choose to not pay the millions borrowed by 38 Studios. Such a decision, however, comes with a heavy price.

"If the state walks away from its obligation, it would be tantamount to defaulting and it will harm its financial reputation," Cafcas said. "There's already some talk out there of credit rating agencies downgrading their credit rating. What was supposed to be a deal that brings in more jobs in the short term could potentially harm long-term job growth in Rhode Island if the cost of borrowing for schools, roads and improving infrastructure goes up."

The debacle involving Schilling's company demonstrates why public entities should never be involved in picking winners and losers, several experts said. One reason is that such entities typically do not have the necessary background to make informed judgments on the viability of companies in the private sector.

"Any time you get into the entertainment space, it's a high-risk proposition because customers are so fickle," said Walt Borland, president and CEO of the Nevada Institute for Renewable Energy Commercialization. "I mean, when you look at Rhode Island, what unique qualities or attributes does it have to play in the gaming industry? I see nothing that would justify investing $75 million, which is just an onerous amount of money to spend on a single deal, by the way."

The risk involved with investing in private entities is also a reason why Darik Volpa, CEO of Understand.com, is wary of taking public funding. Prior to forming his new venture, Volpa was on the board of a company that launched an unsuccessful bid to get incentives from Rhode Island. Volpa said he was against applying for public funding but was outvoted by his colleagues.

"The thing is, investing is a nasty, unforgiving world that's high-risk and high-reward," Volpa said. "Private investors understand that, so that's okay. Philosophically, though, it makes it hard for me to take public funding."

With other areas going all-in with public-private programs, however, states such as Nevada feel that they have no choice if they want to stay competitive. As states try to position themselves for the more tech-oriented new economy, having public-private initiatives is seen as one way to elbow their way into the ongoing discussion and remain relevant.

"Economic development is a contact sport," Hill said. "Some of the decisions we make probably won't work out well but I don't think the standard should be to never make a mistake. I think it should be overall, how much good did a program do for the state and was it worth doing it?"

This piece originally appeared in Distro Issue #55.

[Photo credit: Steven Senne, AP]

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[Photo credit: Rodolfo Gonzales, Statesman.com via AP]

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