VMware virtual machines have a property known as the virtual hardware version – if you’re into .vmx-file diving, it’s the virtualHW.version field. The virtual hardware version is how we manage the file format, and is sort of like Word 98 vs. Word 2008 – newer file formats are needed to support new features that were unthought of years ago. The virtual hardware version is analogous to a motherboard in a physical computer – upgrade the virtual hardware version to upgrade the virtual machine. Many times, new features like enhanced 3D or more device support depends on extending various parts of the file format (for example, for the technically minded, we might have to add more registers or card slots).
If you upgrade from VMware Fusion 1.x to Fusion 2.0, you’ll probably be asked if you want to upgrade a virtual machine; in other words, you’re being asked if you want to upgrade to the newer file format. If you want improved 3D in XP or Vista, upgrading the virtual hardware is a good idea. On the other hand, there’s not much point in upgrading a DOS virtual machine since at best DOS will ignore the new hardware and at worst will freak out. You can always upgrade later by selecting "Virtual Machine > Upgrade Virtual Machine…"
If you downgrade from VMware Fusion 2.0 to Fusion 1.x, you might see a warning that a virtual machine was created with newer features that Fusion 1.x doesn’t know how to handle. To get around this, have Fusion 2.0 downgrade the virtual hardware by selecting "Virtual Machine > Downgrade Virtual Machine…" This way, Fusion 1.x will recognize the virtual machine.
Since we use the same virtual hardware version to mean the same thing across all our products, what I’ve said also applies to Workstation, Player, Server, and so on. Fusion 2.0 uses virtual hardware version 7, the same as Workstation 6.5, Player 2.5, and Server 2.0. Fusion 1.x uses virtual hardware version 6, the same as Workstation 6.0.x, Player 2.0.x, and Server 1.x.