Simple definition
A VM hardware version specifies virtual device capabilities and the minimum compatible hypervisor generation.
Purpose and use
A virtual-hardware version defines the capabilities and virtual devices available to a VM on a platform.
How does it work?
It is tied to features supported by the hypervisor versions able to host that VM.
Example and verification
Check guest OS, guest tools and every target host before changing the version.
Points to watch
Upgrading it does not automatically update the guest OS or necessarily improve performance.
In short
Track virtual hardware, hypervisor version and guest operating system separately.