If I vested 100 options in StartupCo at a strike of $1 and I exercise
then I will have paid $100 for those shares of StartupCo.
100 shares / Cost basis $100
If BigCorp acquires StartupCo and I receive $5 and .25 shares in
BigCorp (market value $10 on day of the transaction) per share in
StartupCo then I'll receive $500 and 25 shares in BigCorp worth $250.
The notice would spell out the tax consequence of this transaction. But, as I read this, 2/3 of the value at that moment is replaced with cash, 1/3 with stock. $66.67 of your investment returned $500, and tax is due on that difference. (Thank-you, Dave, for comment.)
You now own 25 shares of BigCorp, with a basis of $33.33 (1/3 the original basis)
3 years down the road MegaCorp acquires BigCorp at $2/share and upon
surrendering my certificate MegaCorp cuts me a check for $50.
The long term gain is $16.67
I'm sad that I didn't sell shares in BigCorp at the time of the
transaction but more importantly, what is my cost basis for the shares
in BigCorp? And are they sold at a loss since BigCorp was at $10 on
the day of the acquisition but now they're only worth $2?
See the math above. And a warning. All takeovers come with a notice of how to allocate basis. It's easy if there's a takeover of 100% cash, it's just a sale. The cash/stock mix is rarely as clean as my answer suggests. That notice would tell you the exact percents. The funny thing about the market? I can always wish I bought lower, sold higher. If I bought at the very low, and sold at very high, I'd just wish I bought more. It's possible to invest and grow rich over time, but never be happy with the short term results.