This option allows you to add a vault from any supported file provider. Default implementations by Apple are iCloud Drive and On My iPhone/iPad. Inside the Files app, you can also add custom connections to SMB-compatible servers.
If you have a lot of apps installed that include a file provider, you may notice that most of them are grayed out. This is because third-party file providers usually don't support "picking folders". To our best of knowledge, this is unsupported by Apple. You can find a technical discussion here.