Homozygous mutant (Shp-2^Δ46-110) embryonic stem (ES) cells exhibit decreased hematopoiesis; however, the point at which Shp-2 is critical for ES cell differentiation to hematopoietic cells is unknown. We characterized the differentiation defect of Shp-2^Δ46-110 ES cells by examining early points of differentiation, conducting leukemia inhibitory factor (LIF)–stimulated biochemical analysis, and performing in vitro reconstitution studies with wild-type (WT) Shp-2. ES cell in vitro differentiation assays were used to compare the differentiation of WT, Shp-2^Δ46-110, and reconstituted ES cells to mesoderm, by measuring brachyury expression, to hemangioblasts, by measuring blast colony-forming cell (BL-CFC) formation and flk-1 expression, and to hematopoietic progenitor colony-forming cells, by performing secondary plating assays. LIF-stimulated phospho-Stat3 (known to be critical for ES cell self-renewal and maintenance of an undifferentiated state) and phospho-Erk levels were examined by immunoblotting. ES cell survival, using annexin V staining, and secondary embryoid body (EB) formation were also evaluated. Differentiation to both mesoderm and hemangioblasts was lower in Shp-2^Δ46-110 cells compared to WT cells. On reconstitution with WT Shp-2, expression of brachyury and flk-1 and differentiation to hemangioblasts and primitive and definitive hematopoietic progenitors were restored. LIF-stimulated phospho-Stat3 levels were higher, whereas phospho-Erk levels were lower in Shp-2^Δ46-110 ES cells than in WT and reconstituted cells. The increased phospho-Stat3 levels correlated with increased Shp-2^Δ46-110 ES cell secondary EB formation and survival. We conclude that normal Shp-2 function is critical for the initial step of ES cell differentiation to mesoderm and to hemangioblasts and acts within the LIF-gp130-Stat3 pathway to maintain a proper balance of ES cell differentiation, pluripotency, and apoptosis.