Is anything lost or broken by using 1.1a4 over 1.0 Final? 
Or is 1.1a4 just 1.0 Final with the extra new features? 

Would it be easier to add documentation into Divinewolf's KFM?

I don't see an issue with having 1 version that comes with 12 characters to help aid in developmental purposes.

Regular KFM (updated documentation?)
720 KFM is exactly the same as regular but with hires sprites, right? So he can be replaced with a hi res character from a different series.
I still feel DW's KFM should stay in because it uses the KFM base and really expands on it.
Trainer needs to be in but can go back to being 1 character with documentation on how to change him.

So that would leave 9 spots for diversity purposes.
3 Capcom
3 SNK
3 other?

Not turning down the suggestions made thus far. I'm just wanting to get a consensus on this.
Since it's an option I don't see an issue with making a loaded version. The regular version will still have developer tools, anim standards, etc. It'd be what you "keep it light" people would be asking for

F'ing Jesuszilla. The bastard hasn't posted in one year and yet people still preach his 'crouch while runing is a mugen sin' gospel.

Add a Touhou character that uses official SWR or UNL gameplay, then.

Melty Blood characters are also relatively common in Mugen, although I don't know much about their gameplay, you might want to include one.

If it's something that can be done with code alone and KFM's unchanged SFF (I haven't dealt with SFFs or Clsn-defining software in ages, so I'm less comfortable with that), maybe I can spare some time to take a crack at it.
It would just be very very weird to have a non-Elecbyte original be the tutorial character, and even if a modified one was provided, the original should still be there, might help people see how different two takes on the same character can be.

Don't bring the whole characters from existing games (not to mention that list was way too Capcom-centric...) - give the modified KFM their relevant distinguishing or common-but-not-in KFM features that the original lacks. "PotS-style" KFM with whatever extra features that could be relevant?

What else?
Might as well drop double jumping from the hypothetical alternate KFM, since that's a feature of some games that would be heresy in others.

It's not a very good point, Elecbyte's character should be in Elecbyte's engine - not that it's problems shouldn't be pionted out, but it should be there.

There's a grand total of 20 3rd Strike characters - even if not all of them have been accurately converted (why would anyone do that when the game's not balanced enough to break away from the Chun-Li/Yun paradigm?...), that's a bit of a narrow view on what can or should be done with Mugen.

What's KFM's throw lacking when it comes to teaching grappling?

I still feel DW's KFM should stay in because it uses the KFM base and really expands on it.

So that would leave 9 spots for diversity purposes.
3 Capcom
3 SNK
3 other?

Do not include anything but KFM (updated or otherwise) if you do that you are specifically telling people "this is what you must do and it's what mugen is about" It's not about accurately representing anything. It's an engine you can do what you want with. KFM may not set any standards at all, he's there to show you how the engine works, not how to emulate something else.

Yeah, a touhou, a Blaze Blue, and some other character would be good for the final 3. For Capcom a POTS, SF3, and MVC
SNK would just be KOF? Or KOF, Mark of the Wolf, Samurai Shodown?

How about no characters because adding chars would be hypocritical on the "compilations are frowned upon" stance.