4 lessons from Curt Schilling’s 38 Studios fiasco

June 15, 2012, 1:00 PM UTC

Curt Schilling unveils ‘Kingdoms of Amalur: Reckoning’ during Electronic Arts’ Studio Showcase in July 2010

FORTUNE — Five years ago Curt Schilling was a hero in New England, right up there with Paul Revere, J.F.K., and the mustachioed Dunkin’ Donuts man. Today the former Red Sox pitcher is a pariah after his videogame company went bust, taking hundreds of jobs and at least $75 million in taxpayer money along with it. To his dwindling number of defenders, Schilling is a good guy with a lousy business sense. To his growing legion of detractors, he’s a hypocrite. To everyone, he should be a cautionary tale.

The full story of Schilling and 38 Studios is complicated, so here’s the game summary: Schilling founded 38 Studios in Massachusetts five years ago to pursue a personal passion for massive multiplayer online games, which are web-based games that can be played by thousands of people simultaneously. He tried to raise venture capital, but couldn’t. So he plugged more than $30 million of his savings into the company and in 2009 bought a large studio in Maryland that created single-player games. In 2010, 38 Studios received a $75 million loan guarantee from Rhode Island in exchange for moving his company’s headquarters there and promising to hire hundreds of new workers (over the objections of future Rhode Island governor Lincoln Chafee). The company later released a popular single-player game and was at least a year from releasing its multiplayer game when it unexpectedly defaulted on a $1.1 million interest payment to Rhode Island in May. Schilling tried getting alternative funding from private investors or tax credits from the state, but failed, and 38 Studios fired all of its workers in Rhode Island and Maryland — around 400 people.

It is obviously a terrible situation for those who lost their jobs — and for a tiny state already facing giant fiscal problems. But there are four lessons that could help prevent the next 38 Studios.

Stop letting politicians play venture capitalist. Most professional venture capitalists lose money, so why would amateurs in political office do any better? Create the conditions for businesses and emerging industries to succeed, and then let the private market have at it.

If they insist on playing VC, they should share the risk. The most egregious part of Rhode Island’s loan to 38 Studios was that it required no validation from outside investors. Venture capitalists, who are always said to have too much money chasing too few deals, had all passed. Did that not set off any alarms in Providence? Say what you will about Solyndra, but at least the company was required to raise private matching funds before getting federal dollars. Obviously it isn’t foolproof (see No. 1), but there is judgmental and financial value in shared risk with third parties.

Dogma mixed with dollars can be toxic. Schilling has been an outspoken conservative, loudly endorsing “limited government.” But he basically begged Massachusetts for subsidies and, when that failed, took a massive loan guarantee from Rhode Island that was financed via state-issued bonds. When he couldn’t pay the interest, he asked for film tax credits or a payment deferral. Not only was Schilling betraying his own public values, but he was also putting his company in a vulnerable position. Schadenfreude matters when you rely on public sentiment to survive. When Schilling absurdly insisted that he wasn’t looking for taxpayer handouts, he shouldn’t have been surprised when those hands turned into fists.

Successful pivots are rare. It is extraordinarily difficult for someone at the top of one field to reach the top of another, totally unrelated field. Schilling did try to hire experienced gaming execs to help fill in the blanks, but ultimately he was an ex-ballplayer in charge of a digital content corporation. And he often fell back on ballplayer habits, like wanting total control (his money, his family members on the board, etc.). Not necessarily a recipe for failure, but certainly not the base ingredients for success.

It’s too bad that Schilling, his workers, and the taxpayers of Rhode Island had to learn that the hard way.

This story is from the July 12, 2012 issue of Fortune.