>>The Local System account needs to have permission to the file you are attempting to access. A quick way to check if this is a permission issue is to change the startup account to something like the Administrator account. If it works it's almost definitely permission related.
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>The file that it tries to access is in the same directory as the Windows Service. This is local. Using Local System, if the Windows Service can be started, at least it goes in the OnStart() event, shouldn't a file in the same directory be accessible?

Are you specifying the full path? Windows services don't start up in the same folder that the DLL is located in. I think it defaults to something weird like \Windows\System32