When you assemble a ship, your blocks are copied to the “shipyard”.
The shipyard is a far away, but still real, location.
Those blocks function as normal, but are “projected” (aka transformed, if you’re a dev) into your camera where the ship “should be” from the physics.
Your interaction with those blocks get projected back to the shipyard.
No entities are involved at any stage. The official name is Ship. “Physics Entity” is not the right term, since they don’t involve entities.
Mod compatibility issues most often occur when a block is doing a distance check between a position in the world (for example the player position) and the position in the shipyard (e.g. the block position). If it uses a custom distance check not modified by Valkyrien Skies, it will detect a very large distance and may refuse user input or cause other problems.
For developer information on the shipyard, see here