Proper axon pathfinding requires that growth cones execute appropriate turns and branching at particular choice points en route to their synaptic targets. Here we demonstrate that the Drosophila metalloprotease tolloid-related (tlr) is required for proper fasciculation/defasciculation of motor axons in the CNS and for normal guidance of many motor axons enroute to their muscle targets. Tlr belongs to a family of developmentally important proteases that process various extracellular matrix components, as well as several TGF-β inhibitory proteins and pro-peptides. We show that Tlr is a circulating enzyme that processes the pro-domains of three Drosophila TGF-β-type ligands, and, in the case of the Activin-like protein Dawdle (Daw), this processing enhances the signaling activity of the ligand in vitro and in vivo. Null mutants of daw, as well as mutations in its receptor babo and its downstream mediator Smad2, all exhibit axon guidance defects that are similar to but less severe than tlr. We suggest that by activating Daw and perhaps other TGF-β ligands, Tlr provides a permissive signal for axon guidance.