The primary goal of this paper is to explain the definition and meaning of small and medium enterprises (SME), the definition of small cities as well as their interdependence and the importance of creating an investment-friendly environment in small cities. The paper contains the definitions of the terms „small and medium enterprises“, „investments“ and „small cities“. The criteria for the sorting of SMEs as well as the compatibility of the criteria in the Croatian legislation and the legislation of the European Union has also been described. The paper also describes the types of investment with the focus on foreign direct investment and its importance to small cities as well as the general development of the Croatian economy. The entrepreneurial infrastructure, which includes entrepreneurial zones and supporting institutions, plays a big role in the development of small cities and the improvement of the investment climate. A large number of factors, such as location, helps investors make a decision on which city to invest in. This paper describes ways on how to improve the investment climate by combining these different factors. The connection and quality of coordination between the national and local level are important for creating the conditions in which SMEs can further develop in small cities, which is why the incentives and measures that help attract investment have been described in the paper. The strategy is a document that provides guidelines for the longterm progress of cities which is why the analysis of the investment environment, as well as advice for its improvement, have been made on the basis of the strategic documents of Slatina and Ivanec. This paper helps understand the definition of small cities and gives basic guidelines for the development of a stimulating environment for SMEs which affects the economic and social growth of small cities and their local community. Key