All Hedgehog (Hh) proteins are released from producing cells despite being synthesized as N- and C-terminally lipidated, membrane-tethered molecules. Thus, a cellular mechanism is needed for Hh solubilization. We previously suggested that a disintegrin and metalloprotease (ADAM)-mediated shedding of Sonic hedgehog (ShhNp) from its lipidated N and C termini results in protein solubilization. This finding, however, seemed at odds with the established role of N-terminal palmitoylation for ShhNp signaling activity. We now resolve this paradox by showing that N-palmitoylation of ShhNp N-terminal peptides is required for their proteolytic removal during solubilization. These peptides otherwise block ShhNp zinc coordination sites required for ShhNp binding to its receptor Patched (Ptc), explaining the essential yet indirect role of N-palmitoylation for ShhNp function. We suggest a functional model in which membrane-tethered multimeric ShhNp is at least partially autoinhibited in trans but is processed into fully active, soluble multimers upon palmitoylation-dependent cleavage of inhibitory N-terminal peptides.