'How to install? ... Tell the Classic prefpane where to look.'? - one does not use a 'System Preferences' utility to install software.
'How to install? ... Just drag your OS9 System Folder (the one with Folder in the name) and Applications OS9 folder to the external.'? - most 'System' installer disc's 'System Folder's are brief in content; thus, no - do not just drag the disc's 'System Folder' to the external (FireWire, presumed) hard disk drive. Use the disc's 'Installer' application. The 'Installer' application will also install the 'Applications (Mac OS 9)' folder.