In addition to @Bhashkar's answer you can also set in your config file (/system/expressionengine/config/config.php):
But I'd highly recommend placing above web root to maximise security:
Typically this could be your setup:
(/home/account being your server account root)
Whereas a non-MSM site would utilise "default_site" folder off of the templates folder, for a MSM enabled site, each site name (short name) would appear as folders inside the templates folder. As mentioned in the EE link above, you have to modify your index.php and admin.php to utilise the above web root path.
"system" folder would be the EE system folder (without the templates or third_party folders.
"add-ons" being your third_party folders (modules/extensions/plugins)
$config['third_party_path'] = '/home/account/add-ons/';
I'd also suggest you avoid an MSM setup where you have one site within another, e.g.
...which can lead to issues with rewrites and www.domain1.com/domain2 urls accessible. A neater more secure setup would be:
Apologies expanded from your original question...!