What do bad sectors mean?
A bad sector is a sector of the disk to which data cannot be written. This may be due to a number of reasons, but to your operating system all that matters is that it can no longer use that portion of the disk. If the disk has yet to be used, or is being reformatted, bad sectors are not really an issue. All recent operating systems map a drive's bad sectors and avoid them while formatting it for use.
Modern hard drives are manufactured with 'spare' sectors which are only used to replace space lost due to bad sectors. This allows a drive to automatically compensate for any slight manufacturing defects which may have resulted in the drive having bad sectors 'out of the box.' When formatting a drive, bad sectors are detected and these 'spare' sectors are used to replace them as necessary.
Where bad sectors become an issue is when previously usable sectors become damaged due to disk error. Any data on these sectors is in danger of being corrupted or destroyed. The operating system has no way of automatically compensating for this loss, potentially leading to data corruption on a larger scale and system instability if the affected data was crucial.
Bad sectors can be created by software errors, or slight errors in the read/write heads which cause the data laid down on that particular sector to be completely illegible, and thus appear as bad to the operating system. This type of 'soft' bad sector can generally be fixed by completely erasing the disk (by writing every sector over with a pattern of zeroes).
Bad sectors created by a mechanical error have a tendency to breed more bad sectors quickly. Since the margin for error inside a working disk is so slim, any surface damage or debris created by a mechanical failure or 'head-crash' will quickly cause more damage as it interferes with the read/write heads. When formatted, a drive with 'hard' bad sectors like these will use the spare sectors to as much as possible replace the existing bad sectors as detailed above. Of course, if the bad sectors are still spreading due to loose particles or surface errors in the disk, the disk will still be unstable. At this point, the only option is to salvage as much data as possible from the drive before it dies completely.
Fortunately there are ways to fix or work around bad sectors on a disk.