Development since version 1.11 was done by Jeff Groves Automatically search for Hot Linked Images within your posts and automatically cache the image
No the plugin will automatically generate the folders for you. They will all be placed under the WordPress upload folder.
If you host has configured the server correctly, you won't have to. But if the plugin tell you the upload folder isn't writable. Then you have to change the upload folder to 777 (chmod 777).