I've been scouring the internet looking for a small Arduino that can power two sensors and a servo. Is there a way of getting a custom one? Does anyone know if theres software out there for creating custom Arduinos and having them made?
You might look into building a circuit, on a breadboard, from basic components. Think Atmel, AtMega instead of Arduino. Depending on your experience and willingness to read datasheets, this might be easier than you imagine. After you have a large-scale working prototype, find miniature surface-mount versions of all of the components. Designing an actual circuit board to connect these things might be the real trick, but if you can get it done then you can have the board made. I believe, am uncertain about this, that there are software tools available that help turn schematics into circuit board designs. This part might be expensive. Getting to the point of having a large-scale working prototype, on the other hand, would be inexpensive and fun. Once you have a board designed you'll have to get it made. Testing this prototype might be difficult and perhaps expensive as well. (Engineers are paid well because they tend to know before construction if a design will work.) If you come up with something that works then selling the extras might pay for having it made.
Look at the ATtiny85 MCU. It's a small 8pin device, and pretty easy to get up and running using Arduino code. You could also use the ATtiny84 which has more pins and still very small.
Start here: https://code.google.com/p/arduino-tiny/
Also, there are plenty of tutorials on setting up and programming them.
Regarding a custom board, your least expensive route would be to design your own. Otherwise you would need to outsource the design.
No, there is no software specifically for designing custom Arduinos. However, the Arduino is open source, so you can design your own if you have the skills.
You can download the schematics for your chosen base design from the Arduino website, then use any PCB design software you like to design your own PCB.
You can then send that PCB design off to China (for example) to have it fabricated, and when you get them back you can solder the components on and hope it works.
Of course, designing and building very small circuits well is a talent that few possess. Hand building circuits with the very tiny components you will need to make it fit into a watch is very difficult and normally requires specialist equipment. That is unless you want your watch to be the size of a dinner plate, like most of the watch kits you can buy.