Coexistence of woody and herbaceous plants may be governed by a complex set of direct and indirect interactions, whose relative importance have been rarely assessed. We experimentally studied woody species establishment in a mixed plant community by disentangling the potential role of such biotic interactions and the effect of environmental variations on them. Seedling establishment of the common eastern Mediterranean shrub species Sarcopoterium spinosum was investigated under different rainfall and light conditions, combined with the effect of the presence of adult shrubs and annual neighbors. We predicted that seedlings will be directly affected by competition with annuals with increasing water availability, while direct effects of adult shrubs will be positive via amelioration of water stress. Indirect effects were expected beneath shrub canopies due to reduced water stressed and light availability for both annuals and shrub seedlings, which may intensify competition between annuals and shrub seedlings. To test these predictions we performed field and garden experiments in which we combined manipulation of shrub and annual presence with manipulations of water availability and light conditions to simulate the effect of shrub canopy. In contrast to our prediction, shrub seedling establishment was not facilitated but inhibited by adult shrubs because of light limitation. As expected, annuals had direct negative effects on shrub seedlings under wet conditions, which shifted to neutral or positive effects under dry conditions. Thus, interactions among shrubs and annuals, and in particular the release from competition during drought years, leads to a counterintuitive positive effect of drought on shrub seedling establishment. Our findings point to the importance of experimentally studying multidimensional interactions for coexistence of different life forms and to the underestimated role of light for success in water-limited ecosystems.