The adult basal ganglia arise from the medial and lateral ganglionic eminences, morphologically distinct structures found in the embryonic telencephalon. We have previously shown that temporal changes in sonic hedgehog (Shh) responsiveness determine the sequential induction of embryonic neurons that populate the medial and lateral ganglionic eminences. In this report, we show that Shh-mediated differentiation of neurons that populate the lateral ganglionic eminence express different combinations of the homeobox-containing transcription factors Dlx, Mash1 and Islet 1/2. Furthermore, we show that N-terminal fatty-acylation of Shh significantly enhances its ability to induce the differentiation of rat E11 telencephalic neurons expressing Dlx, Islet 1/2 or Mash1. Recent evidence indicates that in utero injection of the E9.5 mouse forebrain with retroviruses encoding wild-type Shh induces the ectopic expression of Dlx2 and severe deformities in the brain. In this report, we show that Shh containing a mutation at the site of acylation prevents either of these phenotypes. These results suggest that N-terminal fatty-acylation of Shh may play an important role in Shh-dependent signaling during rodent ventral forebrain formation.