Turbulent environment, crisis, globalization, rapid technical and technological progress, constant changes require new creative ideas from SME, new knowledge and constant innovation. SME should learn to live with constant changes. Knowledge is the driving force of any innovative venture.Isak Adizes points out: "On one occasion, I asked Ferdinand Porsche (the son of a founder of a car company) if he had two choices ahead of you: to lose all your people or to lose all your machines from which to give up before? He answered the machine! Why? What is easier to replace machines or people? Well machines of course. People have become the most valuable assets of SME because they have knowledge .. The recovery, development and competitiveness of SME depends on the ability and speed of using new knowledge and technologies (innovation capabilities). According to the European Commission, the creation, use and commercialization of new knowledge and technologies are essential for achieving competitiveness. The knowledge base encourages the development of innovations. Innovations as the most important source of change occupy a central place in the knowledge economy. Innovative SME are those who have implemented a one innovation. According to the OECD, a knowledge-based economy is an economy based on the creation, use and dissemination of knowledge and information. The innovative SME are the driving force for knowledge-based economy, they are the most efficient, most dynamic and flexible part of the economy and contribute to increasing the overall competitiveness of the Serbian economy. The paper presents the concept of innovative SME, development conditions and limitations. The importance that innovative SME have for the development of the SME sector in Serbia, as well as the creation of a competitive economy. The importance of the knowledge and innovation relation in innovative SME is also shown, as a key factor in the change and development of the economy as a whole.We given guidelines for improvement and further development of innovative SME in Serbia.