More likely what happened is that the company sold for equal or less than the outstanding preferred stock overhang. Another way of saying this: OnLive's investors got all the money (they raised $56MM) and the founders and employees got ZERO for their common stock.
A stock option is a binding CONTRACT to purchase stock (typically common stock when you're dealing w/ employee stock options) at a set price. If a company is acquired and the price of common stock is below the "strike price" of the employee stock options then the employee has a valueless option to buy stock for more than it's worth.
Oftentimes in an "exit" that's just shy of bankruptcy, common stock holders will get nothing and investors will get all the proceeds, often at pennies or nickels on the dollar.
So... Did OnLive screw its employees? Highly unlikely.