The se kinds of things seem to be more and more common. I hope employees take note and protect themselves when they sign up in new places (read no more cliff agreements).
As an employee, you protect yourself in this case (where the company is failing) through having enough cash compensation, skills, and contacts to have a new job before the day is out.
It's upside cases (like the sale of Skype, Zynga IPO) where you protect yourself primarily by not working for dirtbags. Secondarily, a standard contract, reviewed by a lawyer, could work, but I'd trust Google, Facebook, almost any YC startup, Quora, etc. as employers based on the founders, even if I didn't review the documents. Realistically you're not going to be suing over $100k in compensation anyway.
The nice thing is, within Silicon Valley, the set of bad actor companies with respect to stock is pretty small. Zynga and Skype are the only ones I know of, although in some Acqui-Hire situations, current employees are favored above former employees or investors (like Slide -> Google, or in fact many Google acquisitions).
That wouldn't make a difference. When a company is failing, investors are always first in line to get their money back, and in this case there's a lot of investor money to be paid back before anyone else sees a dime.
If by "first in line" you mean that preferred stock owners are ahead of common stock owners you're right.
But there are other creditors that go before any stock holders. One of the main creditors is wages owed to employees for work performed. It's probably small consolation to people who see their equity wiped out, but I've known of companies during the dot-com bubble that went bankrupt and tried to cheat employees out of even that.
Employees invest time and skills (since part of their pay comes from options) but somehow investing mere money (and possibly in more than one company) is rewarded with the better stocks.
And this at a time when the valley is nearly the only place one can invest money in honest businesses (that is to say, those that produce actual value, not just live of the actions of the past or sweetheart government deals).
A "cliff" refers to a time period that must pass before an employee's options vest. It's typical for startups to offer options with a 1 year "cliff" to keep employees from walking away with equity if they don't stick around.
Say an early hire is offered 4% equity with no cliff. That means that .083% will vest each month, and that early employee could walk away with more than tenth of a point of equity after 2 months, likely before they contribute enough value to the company to justify such equity.
Startup employees should view equity as a bonus anyway, and make sure they're earning a market rate unless they're earning really significant equity, because best case scenario the equity will be significantly diluted before an exit, and more likely, the company won't make it to exit, and the stock options will therefore be worthless.
That being said, if the rumor in the article is true, its still a massive dick move, and it probably also cost the company a substantial amount of money in severance pay.
EDIT: It looks like it's Illegal in california (where OnLive is located) to claw back stock options by firing employees without cause [1]. Therefore, if the rumor is true, then OnLive probably had to pay the employees some cash equivalent of the stock options and get them to sign a termination agreement.
P.S. I'm not a lawyer and have nothing more than a cursory understanding of this stuff. This is definitely not legal advice and you should verify everything I say on your own.
If your options (1 option = chance to buy 1 share, at a price that's typically fixed when the options was issued) vest over a three year period, it means you would be issued 1/(12*3) of your total options per month, for three years.
A common clause in such a vesting schedule is a "1 year cliff", meaning you don't actually get any options granted to you for the first year of employment. After a year, you get a third (1 of 3 years) worth of options in a lump sum, then the usual monthly amount each month after that.
If you fire employees before they reach their cliff, they don't get any options, and won't benefit at all from any liquidation event / sale / etc.
