Here at Microsoft, when we talk about Windows Home Server, one of the things that comes up pretty often is a question about hosting WHS in a virtual machine under Virtual Server. Most often people want this because they already have one always-on machine (a doman controller, a media center PC, etc.), and they don't want another.
In discussing the problem, a few key bits of advice have come up, and I thought it would be a good idea to write them down here.
One of the key problems appears when you consider using the WHS to back up the host. It can certainly be done, but when the host goes down, restoring it is a catch 22.
Dedicate whole drives
Take whole drives & put only one file on each - the .VHD. Make it as large as possible.
Use external drives
Make all of WHS's drives external. Consider putting them all in a single enclosure for convenience. eSATA w/ port multipliers may be a good choice.
Have a 2nd physical machine ready
It should already have Virtual Server or Virtual PC installed. A laptop is fine. Make sure it has appropriate ports for the WHS drives.
When the regular host goes down: