(i didn't notice your update today, i have LiveCD32-Full-1.495-a4effa2 as i was typing this.)
hello. i'm an advancemame (DOS) user with limited experience with linux. i used to multiboot winxp with slackware and/or ubuntu but recently prefer minimalist distros like slitaz, tinycore and puppy. i can multiboot several of them from my usbdisk using nomadic frugal installation. it's like several livecd's all in one.
i would still be using DOS for mame'ing but hardware drivers are the limiting factor. winxp or later is ok if one can shave off unneeded files and still get a workable system. tinyxp is perfect but it borders illegality. as i see it, linux is the perfect platform. it's just too daunting for most linux noobs.
allow me to share some insights which i hope will give some familiarity to most dos/win users.
1. this assures that all available partitions are searched for the loop filesystem
cdroot=/dev/sd[a-z][0-9]
2. add/fix support for fat32
i'm assuming fat32 is broken/missing because your ext2/usb was a success while my fat32/usb failed. there does not seem to be a module for it. fat32 is the common factor between linux and win users.
3. probably fix how CDROM is loaded?
this could another reason why the the loopfile can't be found. maybe the type needs to be auto and not fixed to iso9660. the idea is mentioned on this page (modifying initrd):
http://www.gentoo-wiki.info/HOWTO_LiveCD_on_disk4. use SUBDIR parameter
looking at "/init" and "/etc/initrd.scripts" inside initrd, a "SUBDIR" parameter is mentioned. if this is similar to puppylinux's "PSUBDIR", this means that it can bs used as the starting point for searching for the squashfs file. this can be exploited so groovymame files will not clutter the partition root with files.
5. use 8.3 filenames
line #76 of "initrd.defaults" contain this:
LOOPS='/livecd.loop /zisofs /livecd.squashfs /image.squashfs /livecd.gcloop'
maybe you can add "/livecd.sfs" to the list. this allows DOS users to freely copy the entire groovy folder without fear of munging the long filenames. another file that may be important is "boot.catalog". in other distros, i see it as "boot.cat" only. initrd, vmlinuz, system.map are safe. the files under grub/ and memtest/ are not needed by dos users.
6. allow for manual installation
most 3rd party livecd cd-to-usb installer does not always work. some even fail to see the existing multiboot setup and some need to start from a clean partition. i think users should be allowed the choice to keep existing files while installing to an existing partition, whether testing or installing permanently.
altogether, i'm suggesting a simple unpack-and-go setup, to a single folder that can be easily deleted by the user if he decides it's not for him. the entire folder structure can even be copied and preserved (even in DOS, if not using LFN) to another disk if needed. usbdisks are my preferred medium now. i find them easier to copy files to, make bootable, and troubleshoot compared to CD/DVDroms.
sorry for rambling. i hope i explained myself well.