It is increasingly common for founders to have vesting schedules to prevent this exact issue. If the founders have a four year vesting schedule and one founder bails after year one, then they forfeit the un-vested equity.
>Now, each time they go out for another round of funding, their old investors are diluted by the new shares created to sell to new investors.
Yes and no. It depends on the valuation. A previous investor's absolute ownership percentage may decrease in subsequent funding rounds. But, if the valuation increase outpaces the rate of dilution the previous investor winds up ahead. For example, Peter Thiel's ownership in Facebook has been diluted in subsequent funding rounds but the value of his investment has increased many times over based off of the increased valuations.
>My thought is that every 6-12 months or so, we simulate another round of funding.
This sounds overly complicated. Rather than the equity gymnastics, why not implement a profit sharing program for your employees? This seems more appropriate anyway since it sounds like you are focused on running this as a lifestyle business for the long haul.
If you are set on providing equity, then why not just create a standard employee option pool (i.e. carve out 10-20% of shares outstanding to allocate employees)? With four year vesting you take very little risk.