In today's world of e-readers, getting the format on your manuscript is super important. How important? So important that I'll reject your ms if it isn't formatted properly? No way. I'm not that picky. But it is one of the first things I fix in the revisions stage. But if you get your format fixed before it gets to an agent, she might just forget she's reading a ms on her e-reader because it looks just like a real book! Or it's just one less thing for her to notice.
So, what's the correct format? (I'm using Microsoft Word and I'm reading on a Kindle; please let everyone know if there are different standards for different programs.)
Personally, I prefer Times New Roman 12 pt font, but you can use something equivalent (Arial or Courier)--but don't use Harry Potter font or something equally weird. It's about the words, not how clever you are with ClipArt (please don't add ClipArt).
Make sure you have one inch margins all around (this is a throw back from my English Lit days and I have no idea if the margins actually make a difference).
Next, press Select+A on your keyboard (or go up to the Edit drop down menu and choose Select All), this should highlight your entire document. Right click somewhere and go to Paragraph. Under the Indents and Spacing Tab, go to Indentation. Set Left and Right at 0". Set Special for First Line (this will make your paragraphs automatically indent), By .5". Don't ever use the TAB key; this will not show up on an e-reader.
Not done yet. Now go to the next section, still fixing Paragraph, labeled Spacing. Before and After should be 0pt, and Line Spacing should be Double (unless you've been told to use something else). This will make your paragraphs evenly spaced. Don't take for granted that your entire ms is properly spaced already, there are always mistakes.
For new chapters, you can press Enter a few times or, to get the new chapter on a new page, press Ctrl+Enter. This will put your chapter on a new page and show up nicely on an e-reader (if you press Enter too many times then it might show up on the e-reader as a blank page before we get to the new chapter--profoundly annoying for some reason). Also, don't put your chapter titles in fancy fonts. It doesn't even need to be in a bigger font.
Now your ms should be in the correct format. If you have an e-reader handy, or if you can borrow one from a friend, send the doc to yourself and scroll through the pages.
Viola! You've just eliminated a step from the agent's revising process, made your ms look a lot neater, and it looks like a real book on an e-reader!
Update 4/20/11: Reader @Kris informs us that you can use Find and Replace (Ctrl+f) to delete all your tabs by using ^t in MS Word. Thank you Kris for the information! Hopefully that will cut down on the time it takes to reformat your documents.
Update 4/29/11: For new chapters use Ctrl+Enter. I originally said use shift+enter; that does nothing. Thanks Kris (different Kris than above--I feel like I'm in the Twilight Zone, are all Kris's extremely smart?) for pointing this out! Also to @Bonita's question, no, your chapter titles don't need to be centered. I have no preference on this. Do it or not, just don't spend a whole lot of time on it.
Update 3/23/12: Cassandra Marshall has a great checklist for formatting that I stumbled across, you can find it here. Also, if my info becomes obsolete, what with e-readers updating faster than I can type, please do update us masses!
Skim through the comments, several people have been extremely helpful on this topic!