I got the same error, too, but it's working now!
You do in fact have to change the folder name before it works. When you download Knytt Stories, KS Manager is included, but it's not in the right place!
KSM only works if it is in Knytt Stories\3rd Party Tools\Knytt Stories Manager
But if you look at the folder itself, you'll see it's in Knytt Stories\3rd Party Tools\KSManager
So go to the 3rd Party Tools folder, right click on the KSManager folder and rename it to Knytt Stories Manager.
Note: You still won't be able to use KSM from within the KS Editor, though.
Fortunately, you will now be able to double click on Knytt Stories Manager.exe inside that folder, and it will run.
(If you don't rename the folder, then nothing happens at all when you double click the icon.
It doesn't even say it crashed. It just simply won't do anything.)
Disregard my advice. I just tried putting it directly onto the C: drive (without "fixing" the KSManager folder name) and it started working the way it's supposed to: right from the editor. So my problem also was the path name.
I had KS in C:\Downloaded Software\Knytt Stories\, but apparently even that's too long. It doesn't take much to break it, so I would definitely take the other people's advice and take a look at your path name!