My experience is that employees who are underwater get demotivated and eventually just quit. That is why companies are switching to RSUs.

However for AMT (Alternative Minimum Tax) purposes, the price as of your IPO is money you earned, even if you couldn't sell. Which during the dot com crash lead to a lot of people owing more in tax than they made, and with shares that couldn't be sold to cover it. I personally knew several who didn't have to pay taxes for several years afterwards because they were able to carry forward the losses from that disaster.