Over Layer 2: If the VSM and the VEM are in the same Layer 2 domain, the best way to connect them is to use the Layer 2 connectivity mode:
Nexus1000V(config-svs-domain)# svs mode L2
• Over Layer 3: If the VSM and the VEM are in different Layer 2 domains, the Layer 3 connectivity mode should be used:
Nexus1000V(config-svs-domain)# svs mode L3
The Layer 3 mode will encapsulate the packet of the Layer 2 mode using Generic Routing Encapsulation (GRE). This process requires configuration of a VMware VMkernel interface on each VMware ESX host. This VMware VMkernel interface will need to be configured and attached to a port profile with the l3control option.
Nexus1000V(config)# port-profile type vethernet L3vmkernel
Nexus1000V(config-port-profile)#capability l3control
The l3control configuration tells the VEM that it can use this interface to send Layer 3 packets, so even if the Cisco Nexus 1000V Series is a Layer 2 switch, it can send IP packets.
Regardless of the mode of communication between the VSM and the VEM, after the VSM recognizes the VEM, a new module will be virtually inserted into the Cisco Nexus 1000V Series Switch's virtual chassis. The VSM CLI will notify the network administrator that a new module has powered on, much as with a physical chassis.
Extracted from above link.
Please follow the Cisco N1Kv reference and configuration guides for more details.