The Lil' Sheep Dragon is a ferocious beast who lives on Lil' Sheep Dragon Hill (or "Mount Lil' Sheep Dragon", in other places and times). His existence and residence is clearly a reference to the undead sheep from the Homestar cartoon, Most in the Graveyard.
His body is described as being 3 feet long, and his massive bat wings as being 10 miles long. He breathes fire.
In the Christmas special put on by the gang in SPO, Roscoe Sheep is manipulating a Lil' Sheep Dragon robot, and he is alluded to not really existing. However, in-universe this is a movie being made by the characters, so the Lil' Sheep Dragon could still exist. But, it's implied that his existence is more of a legendary question mark than a believed-in phenomena.