Assuming we're working with small categories $\mathcal{C,D}$, the problem with images not being categories requires, for a functor $F$, the map of sets $F: Ob(\mathcal{C}) \to Ob(\mathcal{D})$ not being injective (though this isn't sufficient to insure a problem). The issue that arises is that there may be objects and morphisms $f:W \to X, g:Y \to Z$ in $\mathcal{C}$, where we have no meaningful idea of composition $f \circ g$, but such that $F(X) = F(Y)$ in $\mathcal{D}$ so that $F(f) \circ F(g)$ now makes sense. But we have no reason a priori to assume there's a map $h: X \to Z$ "lifting" the composition.
The easiest way to construct an example is to consider the finite category $\mathcal{I}$ with objects $0,1$ and a unique morphism $f: 0 \to 1$ (obviously there are also the identities). Suppose we have a functor $F: \mathcal{I} \to \mathcal{C}$, for some other category, and suppose $F(0) = F(1) = X \in Ob(\mathcal{C})$. In order for the image to be a category, $F(f) \circ F(f)$ has to be in the image, but the only morphisms in the image are $F(f)$ and the identity on $X$. So the image of $F$ is only a category if $F(f)$ is idempotent, or if it is its own inverse.
is a counterexample because the arrow from $x\to z$, which is the composition of $x\to y$ and $y\to z$, is not in the image?
– Nishant Jul 25 '14 at 04:12