How the numbers of niches and resident stem cells within a particular organ are determined during development and how they may be modulated or corrected is a question with significant medical implications. In the larval ovary of Drosophila melanogaster, somatic precursors for niches, and germ cells that will become germline stem cells, co-develop. Somatic precursors proliferate during the first 3 days of larval development. By mid-third instar, adult terminal filament (TF) (part of the germline stem cell niche) cells first appear, and differentiation terminates 24 h later when 16-20 TFs fully form. The developmental sequence responsible for TF cell determination and final TF numbers is only partially understood. We show that TF formation proceeds through several, hitherto uncharacterized stages, which include an early exit from the cell cycle to form TF precursors and two steps of cell shape change to form the mature TF cells. The Activin receptor Baboon (Babo) is required for somatic precursor cell proliferation and therefore determines the pool of TF precursors available for TF differentiation. During the final differentiation stage, Babo facilitates TF and germ cell differentiation, and promotes the accumulation of Broad-Z1, which is also a target of the steroid hormone ecdysone. Epistasis analysis shows that Activin controls cell proliferation in an ecdysone-independent manner and TF differentiation by affecting ecdysone targets. We propose that this mode of function allows Activin to balance proliferation and differentiation, and to equilibrate niche numbers. These results suggest a novel model for how niche numbers are corrected during development.