The sensory nervous system in the vertebrate head arises from two different cell populations: neural crest and placodal cells. By contrast, in the trunk it originates from neural crest only. How do placode precursors become restricted exclusively to the head and how do multipotent ectodermal cells make the decision to become placodes or neural crest? At neural plate stages, future placode cells are confined to a narrow band in the head ectoderm, the pre-placodal region (PPR). Here, we identify the head mesoderm as the source of PPR inducing signals, reinforced by factors from the neural plate. We show that several independent signals are needed: attenuation of BMP and WNT is required for PPR formation. Together with activation of the FGF pathway, BMP and WNT antagonists can induce the PPR in naïve ectoderm. We also show that WNT signalling plays a crucial role in restricting placode formation to the head. Finally, we demonstrate that the decision of multipotent cells to become placode or neural crest precursors is mediated by WNT proteins: activation of the WNT pathway promotes the generation of neural crest at the expense of placodes. This mechanism explains how the placode territory becomes confined to the head, and how neural crest and placode fates diversify.