We have analysed the function of transforming growth factor beta (TGF-beta) in yolk sac development in mice by generating somatic chimaeras in which the extraembryonic mesoderm, which gives rise to the endothelial and haematopoietic cells of the yolk sac vasculature, is derived from embryonic stem (ES) cells. The ES cells were stably transfected and express either the full-length type II binding receptor or a kinase-deficient mutant of this receptor. Examination of yolk sacs from chimaeras between E8.5 and 9.5, and analysis of marker expression in embryoid bodies from these mutant ES cell lines in prolonged suspension culture demonstrated that (1) a major function of TGF-beta in yolk sac mesoderm is to regulate production and deposition of fibronectin in the extracellular matrix that maintains yolk sac integrity, (2) TGF-beta signalling is not required for differentiation of extraembryonic mesoderm into endothelial cells but is necessary for their subsequent organisation into robust vessels, and (3) TGF-beta signalling must be tightly regulated for the differentiation of primitive haematopoietic cells to take place normally. Together, these results show that defective TGF-beta signalling in the extraembryonic mesoderm alone is sufficient to account for the extraembryonic phenotype reported previously in TGF-beta1(-/-) mice (Dickson, M. C., Martin, J. S., Cousins, F. M., Kulkarni, A. B., Karlsson, S. and Akhurst, R. J. (1995) Development 121, 1845-1854).