γ-secretase-like proteolysis at site 3 (S3), within the transmembrane domain, releases the Notch intracellular domain (NICD) and activates CSL-mediated Notch signaling. S3 processing occurs only in response to ligand binding; however, the molecular basis of this regulation is unknown. Here we demonstrate that ligand binding facilitates cleavage at a novel site (S2), within the extracellular juxtamembrane region, which serves to release ectodomain repression of NICD production. Cleavage at S2 generates a transient intermediate peptide termed NEXT (Notch extracellular truncation). NEXT accumulates when NICD production is blocked by point mutations or γ-secretase inhibitors or by loss of presenilin 1, and inhibition of NEXT eliminates NICD production. Our data demonstrate that S2 cleavage is a ligand-regulated step in the proteolytic cascade leading to Notch activation.