How does the upgrade know if I have a
copy of Vista?
Older versions of Windows allowed you to insert the old CD into the drive; Vista/7 don't allow you to do this. You need a copy of Windows already installed on the drive before upgrading. Of course, you can wipe the drive after it validates and allows you to start partitioning. (Just don't restart!)
If we buy a Windows 7 Upgrade license,
can we do a fresh install without a
working Vista install?
In short, it depends on how corrupted the install is. Nobody really knows what Microsoft checks in its upgrade process; it's a secret.
On what you can do if this doesn't work:
Warning: IANAL, this is likely against Microsoft's EULA, but I consider it ethical if the OEM install is corrupted and will not install normally (always try the definitely legal way first ;)).
You can use the Windows 7 upgrade trick to install Windows 7 without a clean install disk: http://www.pcworld.com/article/174288/windows_7_upgrade_made_cheaper.html
Basically, install Windows with the Upgrade disk (don't worry if it doesn't validate), use
slmgr -rearm to rearm the system (making it look like it's validated for up to 120 days (which is why this is not a permanent solution)) then install Windows AGAIN from the upgrade disk. It should recognize the "upgrade" install, and allow you to install a permanently validated version.