This paper discusses the incentives for innovation when liability is limited or not. Clearly innovative activity involves risk. On the one hand, the risk of firm owners is limited if their liability is limited. On the other hand, credits will be more difficult to receive if liability is limited. We first discuss these issues theoretically. Afterwards, we run Tobit regressions of R&D expenditures and investment with respect to sales on a liability measure and other variables controlling for firm size, age and its location as well as international and national competition in industry, technology intensity of production and other issues. Our sample contains 2545 observations on firm level taken from the so-called "Mannheim Innovation Panel" of the Center for European Economic Research from the years 1995 and 1996. We use only small and medium sized firms with less than 1000 employees because larger firms have mostly a legal form with limited liability. On the one hand, we find that firms with limited liability undertake more R&D than other firms. On the other hand, the legal form has no impact on capital investment.