INTERACTIVE INTELLIGENCE INC - 10-Q Quarterly Report

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

ý	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2002

Or

o		TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from to

Commission File Number 000-27385

INTERACTIVE INTELLIGENCE, INC.

(Exact name of registrant as specified in its charter)

Indiana		35-1933097
(State or other jurisdiction of incorporation or organization)		(IRS Employer Identification No.)

8909 Purdue Road Suite 300 Indianapolis, Indiana 46268
(Address of principal executive offices)

(317) 872-3000
(Registrant's telephone number)

Indicate by checkmark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes ý No o

The number of shares of common stock outstanding on July 31, 2002 was 15,452,998.

TABLE OF CONTENTS

PART I. FINANCIAL INFORMATION

Item 1.		Condensed Consolidated Balance Sheets as of June 30, 2002 and December 31, 2001

		Condensed Consolidated Statements of Operations for the three and six months ended June 30, 2002 and 2001

		Condensed Consolidated Statements of Cash Flows for the six months ended June 30, 2002 and 2001

		Notes to Condensed Consolidated Financial Statements

Item 2.		Management's Discussion and Analysis of Financial Condition and Results of Operations

Item 3.		Quantitative and Qualitative Disclosures About Market Risk

PART II. OTHER INFORMATION

Item 1.		Legal Proceedings

Item 4.		Submission of Matters to a Vote of Security Holders

Item 6.		Exhibits and Reports on Form 8-K

	Signature

PART I. FINANCIAL INFORMATION

Item 1. Condensed Consolidated Financial Statements and Footnotes.

Interactive Intelligence, Inc.

Condensed Consolidated Balance Sheets

(in thousands, except share amounts)

	June 30, 2002			December 31, 2001
	(Unaudited)
Assets
Current assets:
Cash and cash equivalents	$	5,291		$	14,503
Short-term investments	12,378			7,581
Accounts receivable, net of allowance for doubtful accounts accounts of $713 in 2002 and $677 in 2001	8,242			8,424
Prepaid expenses	882			1,116
Other current assets	119			223
Total current assets	26,912			31,847

Property and equipment, net	8,738			9,598

Other assets, net	1,150			1,064
Total assets	$	36,800		$	42,509

Liabilities and shareholders' equity
Current liabilities:
Accounts payable and accrued liabilities	$	3,669		$	3,924
Accrued compensation and related expenses	842			1,096
Deferred revenue	9,830			9,214
Total current liabilities	14,341			14,234

Shareholders' equity:
Preferred stock, no par value; 10,000,000 authorized; no shares issued and outstanding	—			—
Common stock, $0.01 par value; 100,000,000 authorized; 15,422,418 issued and outstanding at June 30, 2002, 15,282,673 issued and outstanding at December 31, 2001	154			153
Additional paid-in capital	63,907			63,485
Accumulated other comprehensive income	81			(13		)
Accumulated deficit	(41,683		)	(35,350		)
Total shareholders' equity	22,459			28,275
Total liabilities and shareholders' equity	$	36,800		$	42,509

See accompanying notes.

Interactive Intelligence, Inc.

Condensed Consolidated Statements of Operations (unaudited)

(in thousands, except per share amounts)

	Three months ended June 30,						Six months ended June 30,
	2002			2001			2002			2001
Revenues:
Software	$	6,947		$	8,379		$	12,993		$	17,291
Services	4,416			4,362			$	8,777		8,130
Total revenues	11,363			12,741			21,770			25,421

Costs and expenses:
Costs of software	250			154			578			303
Costs of services	2,865			3,720			5,888			7,280
Sales and marketing	5,132			5,867			10,563			11,301
Research and development	3,712			3,936			7,618			7,818
General and administrative	1,381			2,033			2,878			3,636
Special charge	682			—			682			—
Total costs and expenses	14,022			15,710			28,207			30,338
Operating loss	(2,659		)	(2,969		)	(6,437		)	(4,917		)

Interest income, net	104			349			233			667
Loss before income taxes	(2,555		)	(2,620		)	(6,204		)	(4,250		)

Income taxes	60			81			129			141

Net loss	$	(2,615	)	$	(2,701	)	$	(6,333	)	$	(4,391	)

Net loss per share:
Basic and diluted	$	(0.17	)	$	(0.18	)	$	(0.41	)	$	(0.29	)

Shares used to compute net loss per share:
Basic and diluted	15,398			15,039			15,368			14,921

See accompanying notes.

Interactive Intelligence, Inc.

Condensed Consolidated Statements of Cash Flows (unaudited)

(in thousands)

	Six months ended June 30,
	2002			2001
Operating activities
Net loss	$	(6,333	)	$	(4,391	)
Adjustments to reconcile net loss to net cash used by operating activities:
Depreciation	2,570			1,962
Amortization of deferred stock-based compensation	66			38
Changes in operating assets and liabilities:
Accounts receivable	182			(1,703		)
Prepaid expenses	234			(425		)
Other current assets	104			(284		)
Accounts payable and accrued liabilities	(255		)	(551		)
Accrued compensation and related expenses	(254		)	761
Deferred revenue	616			4,497
Net cash used by operating activities	(3,070		)	(96		)

Investing activities
Purchases of property and equipment, net	(1,710		)	(3,352		)
Purchases of available-for-sale investments	(9,121		)	(10,225		)
Sales of available-for-sale investments	4,418			4,677
Change in other assets	(86		)	(274		)
Net cash used by investing activities	(6,499		)	(9,174		)

Financing activities
Principal payments on capital lease obligations	—			(255		)
Proceeds from issuances of common stock	248			15,147
Proceeds from stock options exercised	109			268
Net cash provided by financing activities	357			15,160

Net increase (decrease) in cash and cash equivalents	(9,212		)	5,890

Cash and cash equivalents, beginning of period	14,503			1,999
Cash and cash equivalents, end of period	$	5,291		$	7,889

See accompanying notes.

Interactive Intelligence, Inc

Notes to Condensed Consolidated Financial Statements

(Unaudited)

1. Description of Business and Basis of Presentation

Interactive Intelligence, Inc. (“I3” or the “Company”) is a leading provider of software-based interaction management solutions designed to automate communications for contact centers, enterprises, and service providers. Based on an open, unified platform, the Interactive Intelligence product line was designed as a flexible and affordable alternative to traditional telecom solutions. The Company’s products provide a complete communications solution including PBX (private branch exchange), ACD (automated call distributor), IVR (interactive voice response), unified communications, and Internet and wireless functionality. The Company currently derives substantially all of its revenues from licenses of its Interaction Center platform products and related services.

Principal operations of the Company commenced during 1997. Since then, the Company has established wholly-owned subsidiaries in France, Australia and the United Kingdom. The Company also currently has branch offices in Japan, Korea, Malaysia, and the Netherlands. The Company’s products are marketed in North America, Central America, South America, Europe, the Asia/Pacific region, Australia, and South Africa.

The accompanying unaudited financial statements have been prepared in conformity with generally accepted accounting principles for interim financial information and with the instructions for Form 10-Q and Article 10 of Regulation S-X. Accordingly, certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed, or omitted, pursuant to the rules and regulations of the Securities and Exchange Commission. In our opinion, the statements include all adjustments necessary (which are of a normal and recurring nature) for the fair presentation of the results of the interim periods presented.

The balance sheet at December 31, 2001 has been derived from the audited financial statements at that date but does not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements.

These financial statements should be read in conjunction with our audited consolidated financial statements for the year ended December 31, 2001, included in the Company’s Form 10-K for the year ended December 31, 2001, filed with the Securities and Exchange Commission on April 1, 2002. Our results of operations for any interim period are not necessarily indicative of the results of operations for any other interim period or for a full fiscal year.

2. Net Loss Per Common Share

Basic loss per share is calculated based on the weighted-average number of outstanding common shares. Diluted loss per share is calculated based on the weighted-average number of outstanding common shares plus the effect of dilutive potential common shares.

The following table presents the calculation of basic and diluted net loss per share (in thousands, except per share amounts):

	Three Months Ended June 30,						Six Months Ended June 30,
	2002			2001			2002			2001

Net Loss:	$	(2,615	)	$	(2,701	)	$	(6,333	)	$	(4,391	)

Basic and diluted:
Weighted-average shares used to compute net loss per share:	15,398			15,039			15,368			14,921

Basic and diluted net loss per common share:	$	(0.17	)	$	(0.18	)	$	(0.41	)	$	(0.29	)

The Company’s calculation of diluted net loss per share excludes potential common shares as the effect would be antidilutive. Potential common shares are composed of shares of common stock of the Company issuable on the exercise of stock options. Options to purchase 3,205,447 shares of common stock with exercise prices of $0.13 to $50.50 per share were outstanding as of June 30, 2002 and options to purchase 2,558,774 shares of common stock with exercise prices of $0.13 to $50.50 per share were outstanding as of June 30, 2001.

3. Bank Line of Credit

The Company had an unsecured line of credit with a bank in the amount of $5,000,000 with interest to be charged at the bank’s prime rate (4.75% at June 22, 2002). This line of credit expired June 22, 2002.

4. Reclassifications

Certain reclassifications have been made to prior year amounts to conform with the current year presentations.

5. Contingencies

In June 1999 and September 1999, the Company received letters from a competitor in the call center market claiming that the Company's products utilize technologies pioneered and patented by that competitor. The Company's patent counsel has reviewed all of the patents listed in the letters. Based on the advice of the Company's patent counsel, the Company believes that its products do not infringe any of the patents listed in either letter. The Company has discussed its conclusion with the competitor and has also discussed possible licensing of certain technologies from the competitor. The Company cannot assure you that this matter can be resolved amicably without litigation, or that it will ultimately be able to enter into a licensing arrangement on terms and conditions that would not have a material adverse effect on the Company's business, financial condition or results of operations.

In June 2000 and October 2001, the Company received letters from a competitor in the outbound call center market claiming that the Company's products utilize technologies pioneered and patented by the competitor. Although the Company's patent counsel has not determined the validity or applicability of these patents, the Company has discussed the possible licensing of certain technologies from the competitor. The Company cannot assure you that these claims can be resolved amicably without litigation, or that it will be able to enter into licensing arrangements on terms and

conditions that would not have a material adverse effect on the Company's business, financial condition or results of operations.

In July 2000, the Company received a letter from Avaya, Inc., a competitor in the call center market, claiming that the Company's products utilize technologies pioneered and patented by them. As a result of subsequent discussions, the Company accrued an appropriate amount for the licensing of certain technologies related to 2001 and prior years in the financial statements for the year ended December 31, 2001. An agreement was finalized and executed in February 2002 and the Company believes the terms and conditions of the licensing arrangement will not have a material adverse effect on the Company's business, financial condition or results of operations.

In July 2002, the Company received a letter from a consulting firm which has been retained by a telecommunication technology provider to develop and implement a licensing program based on the technology provider's patents. The consulting firm believes a licensing agreement between the Company and the technology provider is appropriate. The Company's patent counsel is in the process of reviewing the patents listed in the letter. To date, the Company's patent counsel has not determined the validity or applicability of these patents. The Company cannot assure you that this matter can be resolved amicably without litigation, or that it will be able to enter into a licensing arrangement on terms and conditions that would not have a material adverse effect on the Company's business, financial condition or results of operations.

Other third parties could claim that our technology infringes their proprietary rights. Infringement claims, even if without merit, can be time consuming and expensive to defend. A third party asserting infringement claims against us or our customers with respect to our current or future products may require us to enter into costly royalty arrangements or litigation, or otherwise materially adversely affect us.

From time to time, the Company is also involved in certain legal proceedings in the ordinary course of conducting our business. While the ultimate liability pursuant to these actions cannot currently be determined, the Company believes these legal proceedings will not have a material adverse effect on the Company’s financial position.

6. Special Charge

On April 4, 2002, the Company commenced a restructuring program to reduce expense and improve efficiency due to macro-economic and capital spending issues affecting our industry. The restructuring program was substantially completed by the end of the second quarter of 2002 and totaled approximately $682,000, which was classified as operating expenses. The restructuring program consisted of reducing approximately 10% of the Company’s worldwide workforce. The reduction in staff affected most business functions and geographic regions. Nearly all of the $682,000 recorded as restructuring charges related to severance payments and fringe benefits.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Forward-Looking Information

Certain statements in this Form 10-Q contain "forward-looking" information (as defined in Section 27A of the Securities Act of 1933, as amended and Section 21E of the Securities Exchange Act of 1934, as amended) that involves risks and uncertainties which may cause actual results to differ materially from those predicted in the forward-looking statements. Forward-looking statements can be identified by their use of such verbs as "expects," "anticipates," and "believes" or similar verbs or conjugations of such verbs. If any of our assumptions on which the statements are based prove incorrect or should unanticipated circumstances arise, our actual results could materially differ from those anticipated by such forward-looking statements. The differences could be caused by a number of factors or combination of factors, including, but not limited to, the "Factors Affecting Operating Results" described herein and the Risk Factors described in our Securities and Exchange Commission filings, including the Form 10-K filing for the year ended December 31, 2001.

Overview

We commenced operations in October 1994. Through the end of 1996, we focused primarily on research and development activities. Our first product was released in March 1997. In 1997 and 1998, we expanded our operations to capitalize on the increased market demand for communications and interaction management software. We decided, at the expense of profitability, to continue investing significantly in research and development, and to accelerate our investments in marketing, services and sales operations. We had no revenue in 1996, and our total revenues were $1.6 million in 1997, $9.0 million in 1998, $19.1 million in 1999, $38.6 million in 2000, and $50.1 million in 2001. However, we cannot assure you that our revenues will grow at such rates or at all in the future. We believe our investments in research and development and in marketing, services and sales operations will continue to be critical to any revenue growth we experience. However, these investments have also significantly increased our operating costs and expenses, contributing to the net losses and operating losses that we have incurred in each fiscal quarter

since our formation. We anticipate that our operating costs and expenses will increase for the foreseeable future as we continue to emphasize our research and development, marketing, services and sales operations. Accordingly, we are likely to continue to experience losses and negative cash flows from operations in future quarters. We cannot assure you when or if we will achieve profitability or, if achieved, that we will be able to sustain profitability. Our operating results have varied significantly from quarter to quarter and may continue to do so in the future. As a result, we believe that period-to-period comparisons of our operating results are not necessarily meaningful, and you should not rely on them as an indication of our future performance.

On April 4, 2002, we commenced a restructuring program to reduce expenses and improve efficiency due to macro-economic and capital spending issues affecting our industry. The restructuring program resulted in the reduction of approximately 10% of the worldwide workforce. This reduction affected most business functions and geographic regions. The financial impact of the restructuring charges is $682,000 for the period ending June 30, 2002.

Sources of Revenue and Revenue Recognition Policy

We generate a majority of our revenues from software license fees. Most of our software license fees originate from the marketing efforts of our resellers, who are authorized to place software orders with us on behalf of end-user customers. We share end-user customer software license fees with these resellers in varying percentages of our list price, according to the terms of their reseller agreements. In addition to generating software license fees indirectly through resellers, we also receive some software license fees from end-user customers that we contract with directly.

In accordance with AICPA Statement of Position (SOP) 97-2 as amended by SOP 98-4 and SOP 98-9, software license revenues can be recognized upon the shipment of software if:

• persuasive evidence of an arrangement exists,

• sufficient vendor-specific objective evidence exists to support allocating the total fee to all elements of the arrangement,

• the fee is fixed or determinable, and

• collection is probable.

As a result, we typically recognize software license fees only when a reseller places a binding order for our software, which gives the reseller the right to distribute our products to end-user customers, or when an end-user customer directly signs a binding contract for our software. If an order includes an acceptance period, we recognize revenues upon the earlier of order acceptance or the expiration of the acceptance period.

We also generate revenues from services that we provide to our resellers and end-user customers. Services revenues include product maintenance revenues, which consist of technical support and product upgrades, educational services and professional services. Our initial software license generally includes one year of maintenance. Generally, to continue using our software after this initial period, our end-user customers must purchase annual ongoing product maintenance, which is priced at approximately 18% of the current list price of the licensed product. We share maintenance revenues with those resellers who provide first-level technical support according to the terms of their reseller agreements. When these revenues are shared with resellers, we typically receive between 50% and 70% of the amount charged to the end-user customer. We recognize product maintenance revenues on a straight-line basis over the term of the initial software license and each subsequent annual product maintenance purchase. Revenues from educational services, which consist of training courses for resellers and end-user customers, and professional services, which include implementing and customizing our products for an end-user customer, are typically recognized as the related services are performed.

Historical Results of Operations

The following table presents certain financial data, derived from our unaudited statements of operations, as a percentage of total revenues for the periods indicated. The operating results for the three and six months ended June 30, 2002 and 2001 are not necessarily indicative of the results that may be expected for the full year or for any future period.

	Three months ended June 30,				Six months ended June 30,
	2002		2001		2002		2001
Revenues:
Software	61	%	66	%	60	%	68	%
Services	39		34		40		32
Total revenues	100		100		100		100

Costs and expenses:
Costs of software	2		1		3		1
Costs of services	25		29		27		29
Sales and marketing	45		46		48		44
Research and development	33		31		35		31
General and administrative	12		16		13		14
Special charge	6		—		3		—
Total costs and expenses	123		123		129		119

Operating loss	(23	)	(23	)	(29	)	(19	)
Interest income (expense), net	1		2		1		3
Loss before income taxes	(22	)	(21	)	(28	)	(16	)
Income taxes	1		—		1		1
Net loss	(23	)%	(21	)%	(29	)%	(17	)%

Revenues

Our total revenues decreased 11% from $12.7 million for the three months ended June 30, 2001 to $11.4 million for the three months ended June 30, 2002. Total revenues decreased 14% from $25.4 million for the six months ended June 30, 2001, to $21.8 million for the six months ended June 30, 2002. Non-North American revenues decreased from $2.3 million and $6.0 million for the three and six months ended June 30, 2001 respectively, to $1.4 million and $3.0 million for the three and six months ended June 30, 2002 respectively. Our revenues are derived primarily from license fees and fees for services, including product maintenance, education services, and professional services. The decrease in total revenues resulted from lower software revenues. While it is difficult to project revenues in the current economic environment, we anticipate software revenues will continue to represent the majority of our revenues for the foreseeable future.

Software. Our software revenues decreased 17% from $8.4 million for the three months ended June 30, 2001, to $6.9 million for the three months ended June 30, 2002. Software revenues decreased 25% from $17.3 million for the six months ended June 30, 2001, to $13.0 million for the six months ended June 30, 2002. We believe the decrease in software revenues resulted from a weak economic environment, particularly in the technology markets, causing many of our customers to delay and/or reduce their capital spending and related professional services.

Services. Services revenues increased 1% from slightly less than $4.4 million for the three months ended June 30, 2001, to slightly more than $4.4 million for the three months ended June 30, 2002. Services revenues increased 8% from $8.1 million for the six month period ended June 30, 2001, to $8.8 million for the six month period ended June 30, 2002. The increase in services revenue was primarily due to an increase in product maintenance revenues, which is related to our growing installed base of end-user customers.

Cost and Expenses

Our total costs and expenses decreased 11% from $15.7 million for the three months ended June 30, 2001, to $14 million for the three months ended June 30, 2002. Similarly, total costs and expenses decreased 7% from $30.3 million for the six months ended June 30, 2001, to $28.2 million for the six months ended June 30, 2002. The decrease in amount was primarily due to the result of the implementation of our restructuring plans to reduce expenses, as well as lower revenues and increased operating efficiencies.

Costs of Software. Costs of software consist primarily of product royalties paid to third-parties for the use of their technologies in our products and, to a lesser extent, software packaging costs, which include product media, duplication and documentation. Costs of software increased from $154,000 for the three months ended June 30, 2001, to $250,000 for the three months ended June 30, 2002. Costs of software increased from $303,000 for the six months ended June 30, 2001 to $578,000 for the six months ended June 30, 2002. This represents 2% of software revenues for the three months and six months ended June 30, 2001, and 4% for the three months and six months ended June 30, 2002. The dollar increase was due to royalties owed as a result of additional licensing of third-party technology associated with the releases of our Interaction Center Platform™ products and other related products. We expect product royalties to continue to increase as we release additional products, release additional versions of our existing products, and integrate additional third-party software functions and features into our product offerings.

Costs of Services. Costs of services consist primarily of compensation expenses for technical support, education, and professional services personnel and other costs associated with supporting our resellers and end-user customers. Costs of services decreased from $3.7 million for the three months ended June 30, 2001, to $2.9 million for the three months ended June 30, 2002. Costs of services decreased from $7.3 million for the six months ended June 30, 2001, to $5.9 million for the six months ended June 30, 2002. As a percentage of services revenues, cost of services represented 85% and 65% for the three months ended June 30, 2001 and 2002, respectively, and 90% and 67% for the six months ended June 30, 2001 and 2002, respectively. The dollar decrease is the result of a reduction in employees and expenditures as part of our restructuring plans, lower outsourced services, as well as increased operating efficiencies.

Sales and Marketing. Sales and marketing expenses consist of trade shows, advertising, telemarketing campaigns, public relations and other promotional expenses, compensation expenses (including sales commissions), and travel expenses. Sales and marketing expenses decreased from $5.9 million for the three months ended June 30, 2001, to $5.1 million for the three months ended June 30, 2002. Sales and marketing expenses decreased from $11.3 million for the six months ended June 30, 2001 to $10.6 million for the six months ended June 30, 2002. The decrease is the result of a reduction in employees and marketing program expenditures following the implementation of our restructuring plans, and decreased commissions due to lower sales. As we continue to focus on sales growth and develop awareness for our products, we plan to continue investing significantly in sales and marketing efforts.

Research and Development. Research and development expenses consist primarily of compensation expenses for our developers and third party efforts to develop and enhance our products; including adapting our products for specific non-English languages and allowing our products to effectively run with alternative hardware configurations. Research and development expenses decreased from $3.9 million for

the three months ended June 30, 2001, to $3.7 million for the three months ended June 30, 2002. Research and development expenses decreased from $7.8 million for the six months ended June 30, 2001, to $7.6 million for the six months ended June 30, 2002. Currently, all costs related to research and development of our products are charged to research and development expense as incurred. These decreases are the results of a reduction in employees following the implementation of our restructuring plans. We believe that a significant investment in research and development has been, and will continue to be, critical to market acceptance of our products.

General and Administrative. General and administrative expenses consist primarily of compensation for our administrative, financial, and information technology personnel, and a number of non-allocable costs, including legal and other professional service fees. General and administrative expenses decreased from $2.0 million for the three months ended June 30, 2001, to $1.4 million for the three months ended June 30, 2002. General and administrative expenses decreased from $3.6 million for the six months ended June 30, 2001 to $2.9 million for the six months ended June 30, 2002. The decreases are primarily due to lower bad debt expense and savings associated with our restructuring initiatives taken, including lower staffing levels and cost controls.

Special charges. For the three and six months ended June 30, 2002, we incurred a special charge of $682,000, primarily consisting of severance, benefits and other related costs from the reduction of our workforce by 10%, or approximately 45 people. Global functions impacted by the restructuring included sales and sales infrastructure, support services, marketing, research and development, and administration.

Interest income, net

Interest income, net is generated primarily from invested funds from our initial public offering completed in September 1999 and the equity investment made by Cisco Systems, Inc. (“Cisco”) on January 25, 2001. Net interest income decreased from $349,000 for the three months ended June 30, 2001 to $104,000 for the three months ended June 30, 2002. Net interest income decreased from $667,000 for the six months ended June 30, 2001 to $233,000 for the six months ended June 30, 2002. This decrease can be attributed to both the substantial decrease in U.S. interest rates and less cash on hand.

Income taxes

For U.S. corporate income tax purposes, we did not recognize a tax benefit related to U.S. federal or state income taxes during the three months or six months ended June 30, 2001 or June 30, 2002 because of the uncertainty of eventually realizing these benefits. However, we did recognize a tax expense related to our international operations of $60,000 for the three months ended June 30, 2002, and $129,000 for the six months ended June 30, 2002.

Liquidity and Capital Resources

As of June 30, 2002, we had cash and cash equivalents of $5.3 million, $12.4 million in short term investments, and a working capital balance of $12.6 million.

In September 1999, we sold 3.0 million shares of common stock in our initial public offering, generating $39.0 million in cash, before offering expenses. Prior to our initial public offering, we funded our operations primarily through equity and debt infusions from our principal shareholder, Dr. Donald E. Brown, a $5.0 million equity investment by Dialogic Investment Corporation (formerly a subsidiary of Dialogic Corporation), and borrowings under commercial lines of credit.

On January 25, 2001 we received an equity investment from Cisco Systems, Inc. We sold 515,517 shares of common stock at a price of $29.00 per share, yielding approximately $15.0 million in cash.

Our operating activities resulted in a net cash outflow of $3.1 million for the six months ended June 30, 2002, and a net cash outflow of $96,000 for the six months ended June 30, 2001. The net operating cash outflow for the first six months of 2002 was primarily the result of our operating loss, excluding the

non-cash depreciation amount, partially offset by an increase in deferred revenue. The net operating cash outflow for the first six months of 2001 was primarily due to the operating loss excluding the non-cash depreciation amount, an increase in accounts receivable, prepaid expenses and a decrease in accounts payable, partially offset by in increase in deferred revenue and accrued compensation.

Our investing activities have consisted primarily of capital expenditures for property and equipment and purchases and sales of investments. Our activities resulted in a $6.5 million outflow for the six months period ended June 30, 2002 and a $9.2 million outflow for the six months period ended June 30, 2001. The difference in cash outflow between the first six months of 2001 and 2002 was attributed to less net purchases of available-for-sale investments and capital expenditures for property and equipment. At June 30, 2002, we did not have any material commitments for future capital expenditures.

In April 2001, we entered into a 15 year non-cancelable lease agreement for a new, approximately 120,000 square foot corporate headquarters building with a targeted occupation date of April 2003. Over the life of the lease, we are committed to expend approximately $35.0 million in rent payments.

For the six months ended June 30, 2002 we generated $357,000 from financing activities attributed to the issuance of common stock and stock option exercises.

At June 30, 2002, we had no amounts outstanding on our line of credit and were in compliance with all related covenants and restrictions. This line of credit expired on June 22, 2002. We did not renew the line of credit.

We believe that our existing cash and cash equivalents and short-term investments will be sufficient to meet our working capital and capital expenditure requirements for at least the next 12 months. After that time, we may require additional funds to support our working capital requirements or for other corporate purposes, and we may seek to raise additional funds through public or private equity or debt financings or from other sources. We cannot assure you that additional financing will be available at all or that, if available, it will be on terms favorable to us or that any additional financing will not dilute your ownership interest in Interactive Intelligence.

Factors Affecting Operating Results

OUR LIMITED OPERATING HISTORY MAKES FINANCIAL FORECASTING DIFFICULT AND, IN ASSESSING OUR PROSPECTS, YOU SHOULD CONSIDER OUR EARLY STAGE OF DEVELOPMENT AND PRESENCE IN A NEW AND RAPIDLY EVOLVING INDUSTRY

Our limited operating history makes it difficult to forecast our future operating results. We commenced operations in October 1994, but did not begin shipping an Interaction Center Platformä-based product until 1997. In 1999, we began shipping Interaction Recorderâ, Interaction Dialer™, and e-FAQ™. Accordingly, you should assess our prospects in light of the risks and difficulties frequently encountered by companies in the early stage of development, particularly companies in new and rapidly evolving industries.

WE HAVE HISTORICALLY INCURRED LOSSES AND WE MAY NOT ACHIEVE PROFITABILITY

We have not operated profitably to date. We incurred net losses of $9.0 million, $4.6 million, and $7.1 million in 2001, 2000, and 1999, respectively. At June 30, 2002, we had accumulated losses since inception of $41.7 million. We intend to continue to make significant investments in our research and development, marketing, services and sales operations. We anticipate that these expenses could significantly precede any revenues generated by the increased spending. As a result, we may continue to experience losses and negative cash flow from operations in future quarters. If we do become profitable, we may not sustain or increase our profitability.

OUR QUARTERLY OPERATING RESULTS HAVE VARIED SIGNIFICANTLY AND, IF SEVERAL FACTORS AFFECTING OUR BUSINESS CAUSE THEM TO CONTINUE TO DO SO, THE MARKET PRICE OF OUR COMMON STOCK COULD BE AFFECTED

Our operating results have varied significantly from quarter to quarter and may continue to do so in the future depending on a number of factors affecting us or our industry, including many that are beyond our control. As a result, we believe that period-to-period comparisons of our operating results are not necessarily meaningful, and you should not rely on them as an indication of our future performance. In addition, our operating results in a future quarter or quarters may fall below expectations of securities analysts or investors and, as a result, the price of our common stock may fluctuate.

Because we do not know when our potential end-user customers will place orders and finalize contracts, we cannot accurately forecast our revenues and operating results for future quarters. We recognize revenues on satisfaction of the requirements of AICPA Statement of Position 97-2, which generally occurs in the same quarter that the order is received. As a result, our quarterly revenues and operating results depend primarily on the size, quantity and timing of orders received for our products during each quarter. If a large number of orders or several large orders do not occur or are deferred or delayed, our revenues in a quarter could be substantially reduced. This risk is heightened by the significant investment and executive level decision making typically involved in our end-user customers' decisions to license our products. Since a large portion of our operating expenses, including rent and salaries, is fixed and difficult to reduce or modify, our business, financial condition or results of operations could be materially adversely affected if revenues do not meet our expectations.

Because of our early stage of development and limited number of products, changes in pricing policies and the timing of the development, announcement and sale of new or upgraded versions of our products are some of the additional factors that could cause our revenues and operating results to vary significantly from quarter to quarter.

WE HAVE A LENGTHY PRODUCT SALES CYCLE, WHICH HAS CONTRIBUTED, AND MAY CONTINUE TO CONTRIBUTE, TO THE QUARTER-TO-QUARTER VARIABILITY OF OUR REVENUES AND OPERATING RESULTS, WHICH COULD AFFECT THE MARKET PRICE OF OUR COMMON STOCK

We have generally experienced a lengthy product sales cycle, averaging approximately six to nine months. The lengthy sales cycle is one of the factors that has caused, and may in the future continue to cause, our software revenues and operating results to vary significantly from quarter to quarter, which could affect the market price of our common stock. It also makes it difficult for us to forecast product license revenues. Because of the unique characteristics of our products, our prospective end-user customers' decisions to license our products often require significant investment and executive level decision making. We believe that many companies currently are not aware of the benefits of interaction management software of the type we license or of our products and capabilities. For this reason, we must provide a significant level of education to prospective end-user customers about the use and benefits of our products, which can cause potential end-user customers to take many months to make these decisions. As a result, sales cycles for end-user customer orders vary substantially from customer to customer. Excessive delay in product sales could materially adversely affect our business, financial condition or results of operations.

The length of the sales cycle for end-user customer orders depends on a number of other factors over which we have little or no control, including:

• an end-user customer's budgetary constraints;

• the timing of an end-user customer's budget cycles;

• concerns by end-user customers about the introduction of new products by us or our competitors; and

• downturns in general economic conditions, including reductions in demand for call center services.

In addition, the sales cycle for our products in international markets has been, and is expected to continue to be, longer than the sales cycle in the United States. The average sales cycle for our products may lengthen as we expand internationally.

OUR INABILITY TO MANAGE SUCCESSFULLY OUR INCREASINGLY COMPLEX THIRD PARTY RELATIONSHIPS COULD ADVERSELY AFFECT US

As the complexity of our product technology and our reseller and other third-party relationships have increased, the management of those relationships and the negotiation of contractual terms sufficient to protect our rights and limit our potential liabilities has become more complicated, and we expect this trend to continue in the future. As a result, our inability to successfully manage these relationships or negotiate sufficient contractual terms could have a material adverse effect on us.

WE FACE COMPETITIVE PRESSURES, WHICH MAY HAVE A MATERIAL ADVERSE EFFECT ON US

The market for our software products is highly competitive and, because there are relatively low barriers to entry in the software market, we expect competition to increase significantly in the future. In addition, because our industry is new and evolving and characterized by rapid technological change, it is difficult for us to predict whether, when and by whom new competing technologies or new competitors may be introduced into our markets. Currently, our competition comes from several different market segments, including computer telephony platform developers, computer telephony applications software developers, telecommunications equipment vendors and data networking equipment vendors. We cannot assure you that we will be able to compete effectively against current and future competitors. In addition, increased competition or other competitive pressures may result in price reductions, reduced margins or loss of market share, any of which could have a material adverse effect on our business, financial condition or results of operations.

Many of our current and potential competitors have longer operating histories, significantly greater financial, technical, marketing, customer service and other resources, greater name recognition and a larger installed base of customers than we do. As a result, these competitors may be able to respond to new or emerging technologies and changes in customer requirements faster and more effectively than we can, or to devote greater resources to the development, promotion and sale of products than we can. Current and potential competitors have established, and may in the future establish, cooperative relationships among themselves or with third parties, including mergers or acquisitions, to increase the ability of their products to address the needs of our current or prospective end-user customers. If these competitors were to acquire significant market share, it could have a material adverse effect on our business, financial condition or results of operations.

WE MAY NOT BE ABLE TO GROW OUR BUSINESS IF WE DO NOT MAINTAIN SUCCESSFUL RELATIONSHIPS WITH OUR RESELLERS AND OEM PARTNERS AND CONTINUE TO RECRUIT AND DEVELOP ADDITIONAL SUCCESSFUL RESELLERS AND OEM PARTNERS

Our ability to achieve revenue growth in the future will depend in part on our success in maintaining successful relationships with our existing and future resellers and OEM partners and in recruiting and training additional resellers and OEM partners. We rely primarily on resellers to market and support our products, and plan on relying more on our OEM partners in the future. We are still developing and refining our reseller and OEM distribution networks and may be unable to attract additional resellers with both voice and data expertise or appropriate OEM partners that will be able to market our products effectively and that will be qualified to provide timely and cost-effective customer support and service. We generally do not have long-term or exclusive agreements with our resellers or OEM partners, and the loss of specific larger resellers or OEM partners or a significant number of resellers or OEM partners could materially adversely affect our business, financial condition or results of operations.

OUR MARKETS ARE CHARACTERIZED BY RAPID TECHNOLOGICAL CHANGE WHICH MAY CAUSE US TO INCUR SIGNIFICANT DEVELOPMENT COSTS AND PREVENT US FROM ATTRACTING NEW CUSTOMERS

The market for our products is characterized by rapid technological change, frequent new product introductions and enhancements, uncertain product life cycles and changing end-user customer demands. The introduction of products embodying new technologies and the emergence of new industry standards could render existing products obsolete or unmarketable and cause us to incur significant development costs.

The growth of our business may be impeded without increased use of the Internet

The use of the Internet as a commercial marketplace is at an early stage of development. Demand and market acceptance for recently introduced products and services available over the Internet are still uncertain. In addition, governmental regulation of the Internet, such as imposing sales and other taxes, access charges, and pricing controls and inhibiting cross–border commerce, may reduce the use of the Internet by businesses for their electronic commerce and customer service needs. To date, governmental regulations have not materially restricted commercial use of the Internet. However, the legal and regulatory environment that pertains to the Internet is uncertain and may change. New regulations could reduce the use of the Internet by our end–user customers and, in turn, their customers. The lack of acceptance of the Internet as a forum for conducting business could reduce growth in demand for our products and limit the growth of our revenue.

Our business will be adversely affected if web–based electronic business solutions are not widely adopted

Our products address a relatively new and emerging market for Web–based, interactive electronic business solutions. Therefore, our future success depends on the widespread adoption of the Web as a primary medium for commerce and business applications. The failure of this market to develop, or a delay in the development of this market, could have a material adverse effect on our business, financial condition or results of operations. The Web has experienced, and is expected to continue to experience, significant user and traffic growth, which has, at times, caused user frustration with slow access and download times. The Web infrastructure may not be able to support the demands placed on it by the continued growth on which our success depends. Moreover, critical issues concerning the commercial use of the Web, such as security, reliability, cost, accessibility and quality of service, remain unresolved and may negatively affect the growth of Web use or the attractiveness of commerce and business communication over the Web. In addition, the Web could lose its viability due to delays in the development or adoption of new standards and protocols to handle increased activity or due to increased government regulation and taxation of Internet commerce.

A DECLINE IN MARKET ACCEPTANCE FOR MICROSOFT CORPORATION TECHNOLOGIES ON WHICH OUR PRODUCTS RELY COULD HAVE A MATERIAL ADVERSE EFFECT ON US

Our products currently run only on Microsoft Windows 2000® servers. In addition, our products use other Microsoft Corporation technologies, including Microsoft Exchange Server® and Microsoft SQL Server®. A decline in market acceptance for Microsoft technologies or the increased acceptance of other server technologies could cause us to incur significant development costs and could have a material adverse effect on our ability to market our current products. Although we believe that Microsoft technologies will continue to be widely used by businesses, we cannot assure you that businesses will adopt these technologies as anticipated or will not in the future migrate to other computing technologies that we do not currently support. In addition, our products and technologies must continue to be compatible with new developments in Microsoft technologies.

OUR FUTURE BUSINESS PROSPECTS DEPEND IN PART ON OUR ABILITY TO MAINTAIN AND IMPROVE OUR CURRENT PRODUCTS AND DEVELOP NEW PRODUCTS

We believe that our future business prospects depend in large part on our ability to maintain and improve our current products and to develop new products on a timely basis. Our products will have to achieve market acceptance, maintain technological competitiveness and meet an expanding range of end-user customer requirements. As a result of the complexities inherent in our products, major new products and product enhancements require long development and testing periods. We may not be successful in developing and marketing, on a timely and cost effective basis, product enhancements or new products that respond to technological change, evolving industry standards or end-user customer requirements. We may also experience difficulties that could delay or prevent the successful development, introduction or marketing of product enhancements, and our new products and product enhancements may not achieve market acceptance. Significant delays in the general availability of new releases of our products or significant problems in the installation or implementation of new releases of our products could have a material adverse effect on our business, financial condition or results of operations.

SLOW GROWTH, OR A DECLINE IN DEMAND FOR INTERACTION MANAGEMENT SOFTWARE OF THE TYPE WE LICENSE, COULD MATERIALLY ADVERSELY AFFECT OUR GROWTH PROSPECTS

If the demand for interaction management software of the type we license does not grow within each of our targeted markets, our ability to grow our business could be materially adversely affected. All of our revenues have been generated from licenses of our Interaction Center Platformä software or complementary products, and related support, educational and professional services. We expect these products and services to account for the majority of our revenues for the foreseeable future. Although we believe demand for the functions performed by our products is high, the market for our products and services is still emerging. Further, our growth plans require us to successfully attract enterprise and service provider end-user customers.

If our end–user customers do not perceive our products or the related services provided by us or our resellers or OEM partners to be effective or of high quality, our brand and name recognition will suffer

We believe that establishing and maintaining brand and name recognition is critical for attracting, retaining and expanding end–user customers in our target markets. We also believe that the importance of reputation and name recognition will increase as competition in our market increases. Promotion and enhancement of our name will depend on the effectiveness of our marketing and advertising efforts and on our success in providing high–quality products and related services, neither of which can be assured. If our end–user customers do not perceive our products or related services to be effective or of high quality, our brand and name recognition would suffer which could have a material adverse effect on our business, financial condition or results of operations.

IF WE ARE UNABLE TO ADAPT OUR SOFTWARE IN A WAY THAT WILL PERMIT US TO SERVE LARGE, SINGLE-SITE END-USER CUSTOMERS, THE MARKETABILITY OF OUR PRODUCTS COULD BE ADVERSELY AFFECTED

Our products cannot currently meet the communications needs of organizations with more than 500 users at a single call center location. As these organizations expand to include multiple locations, our products can be customized to increase the number of telephone lines, extensions and users. We will need to adapt our software to serve larger single–site organizations. Although we are currently developing and testing solutions that would enable our software to significantly increase the number of users that our products can serve at a single location, we cannot assure you that we will be able to successfully introduce this technology into a currently available version of our products. Further, we may not be able to adapt our software in a timely or cost effective manner in a way that will permit us to

serve these customers. This inability could have a material adverse effect on our business, financial condition or results of operations.

Our main suppliers of voice processing boards may become unwilling or unable to continue to manufacture and supply us with voice processing boards, requiring us to introduce a substitute supplier which could prove difficult or costly

Dialogic Corporation and AcuLab plc are our primary suppliers of the voice processing boards that are used by a majority of our end-user customers for the operation of our products. If a majority of future end-user customers desire to utilize the voice processing boards to enable our products and these suppliers become unable or unwilling to continue to manufacture and supply these voice processing boards in the volume, price and technical specifications we require, then we would have to adapt our products to a substitute supplier. We may not be able to successfully introduce voice processing boards made by a substitute supplier into the available versions of our products. In addition, introducing a substitute supplier of voice processing boards could result in unforeseen additional product development or customization costs and could also introduce hardware and software operating or compatibility problems. We cannot assure you that these issues will not affect product shipments, will not be costly to correct, will not damage our reputation in the markets in which we operate, or will not have a material adverse affect on our business, financial condition or results of operations.

In addition, Dialogic Corporation’s CT Media™ server software offers some of the functionality that our Interaction Center Platformä products provide and consequently could make it easier for competitors or potential competitors to provide products competitive with ours. If CT Media™ server software were to become an industry standard, our failure to adopt it could disadvantage us in competitive situations. In addition, although neither of our primary suppliers of voice processing boards nor their affiliates currently offer a product that competes with our Interaction Center Platformä products, they could potentially develop a competitive or superior product.

WE MAY NOT BE ABLE TO PROTECT OUR PROPRIETARY RIGHTS ADEQUATELY, WHICH COULD ALLOW THIRD PARTIES TO COPY OR OTHERWISE OBTAIN AND USE OUR TECHNOLOGY WITHOUT AUTHORIZATION

We regard our software products as proprietary. In an effort to protect our proprietary rights, we rely primarily on a combination of copyright, trademark and trade secret laws, as well as licensing and other agreements with consultants, suppliers, strategic and OEM partners, resellers and end–user customers, and employee and third–party non–disclosure agreements. These laws and agreements provide only limited protection of our proprietary rights. In addition, we have not signed agreements containing these types of protective provisions in every case, and the contractual provisions that are in place and the protection they provide vary and may not provide us with adequate protection in all circumstances. We have filed patent applications directed to several inventions embodied in our software products. We currently hold one patent. We hold eight U.S. trademark registrations and 21 foreign trademark registrations, and have numerous other trademark applications pending worldwide, as well as having common law rights in other trademarks and service marks. We hold one registered copyright. Because our means of protecting our proprietary rights may not be adequate, it may be possible for a third party to copy or otherwise obtain and use our technology without authorization. A third party could also develop similar technology independently. In addition, the laws of some countries in which we sell our products do not protect our software and intellectual property rights to the same extent as the laws of the United States. Unauthorized copying, use or reverse engineering of our products could materially adversely affect our business, results of operations or financial condition.

We license technology that is embedded in our products from others. If one or more of these licenses terminates or cannot be renewed on satisfactory terms, we would have to modify the affected products to use alternative technology or eliminate the affected product function, either of which could have a material adverse effect on us.

INFRINGEMENT CLAIMS COULD ADVERSELY AFFECT US

In June 1999 and September 1999, we received letters from a competitor in the call center market claiming that our products utilize technologies pioneered and patented by that competitor. Our patent counsel has reviewed all of the patents listed in the letters. Based on the advice of our patent counsel, we believe that our products do not infringe any of the patents listed in either letter. We have discussed our conclusion with the competitor and have also discussed possible licensing of certain technologies from the competitor. We cannot assure you that this matter can be resolved amicably without litigation, or that we will ultimately be able to enter into a licensing arrangement on terms and conditions that would not have a material adverse effect on our business, financial condition or results of operations.

In June 2000 and October 2001, we received letters from a competitor in the outbound call center market claiming that our products utilize technologies pioneered and patented by the competitor. Although our patent counsel has not determined the validity or applicability of these patents, we have discussed the possible licensing of certain technologies from the competitor. We cannot assure you that these claims can be resolved amicably without litigation, or that we will be able to enter into licensing arrangements on terms and conditions that would not have a material adverse effect on our business, financial condition or results of operations.

In July 2000, we received a letter from Avaya, Inc., a competitor in the call center market, claiming that our products utilize technologies pioneered and patented by them. As a result of subsequent discussions, we accrued an appropriate amount for the licensing of certain technologies related to 2001 and prior years in the financial statements for the year ended December 31, 2001. An agreement was finalized and executed in February 2002 and we believe the terms and conditions of the licensing arrangement will not have a material adverse effect on our business, financial condition or results of operations.

Other third parties could claim that our technology infringes their proprietary rights. As the number of software products in our target markets increases and the functionality of these products overlap, we believe that software developers may face infringement claims. For example, various patent rights have been asserted against interfaces between PBX hardware and computer network systems. Although we believe that our products do not infringe any of these patents because, among other reasons, our products are designed to replace PBXs and not to create such interfaces, if these patents were interpreted broadly, claims of infringement of these patents could have a material adverse affect on us.

Infringement claims, even if without merit, can be time consuming and expensive to defend. A third party asserting infringement claims against us or our customers with respect to our current or future products may require us to enter into costly royalty arrangements or litigation, or otherwise materially adversely affect us.

WE DEPEND ON KEY PERSONNEL AND WILL NEED TO RECRUIT ADDITIONAL SKILLED PERSONNEL, FOR WHICH COMPETITION IS INTENSE, TO CONDUCT AND GROW OUR BUSINESS EFFECTIVELY

Our success depends in large part on the continued service of our key personnel, particularly Dr. Donald E. Brown, our Chief Executive Officer and principal stockholder. The loss of the services of Dr. Donald E Brown or any key personnel could have a material adverse effect on our business, financial condition or results of operations. We do not have key man life insurance on any of our employees. Our future success also depends on our ability to attract, train, assimilate and retain additional qualified personnel. Competition for persons with skills in the software industry is intense, particularly for those with relevant technical and/or sales experience. We cannot assure you that we will be able to retain our key employees or that we can attract, train, assimilate or retain other highly qualified personnel in the future.

OUR WORKFORCE REDUCTION AND FINANCIAL PERFORMANCE MAY ADVERSELY AFFECT THE MORALE AND PERFORMANCE OF OUR PERSONNEL AND OUR ABILITY TO HIRE NEW PERSONNEL

In connection with our effort to streamline operations, reduce costs and rationalize our staffing and structure, we had a reduction in both 2001 and April 2002 of our worldwide workforce of approximately 10% each. There were and may continue to be substantial costs associated with the workforce reductions related to severance and other employee-related costs, and our restructuring plans may still yield unanticipated consequences, such as attrition beyond our implemented reduction in workforce. As a result, our ability to respond to unexpected challenges may be impaired and we may be unable to take advantage of new opportunities. The reduction in workforce may reduce employee morale and may create concern among existing employees about job security, which may lead to increased turnover. These reductions in headcount may still subject us to the risk of litigation. In addition, recent trading levels of our common stock have decreased the value of the stock options granted to employees pursuant to our stock option plans. As a result of these factors, our remaining personnel may seek employment with larger, more established companies or companies they perceive as having less volatile stock prices.

WE MAY PURSUE ACQUISITIONS THAT BY THEIR NATURE PRESENT RISKS AND THAT MAY NOT BE SUCCESSFUL

In the future we may pursue additional acquisitions to diversify our product offerings and customer base or for other strategic purposes. We have no prior history of making material acquisitions and we cannot assure you that any future acquisitions will be successful. The following are some of the risks associated with acquisitions that could have a material adverse effect on our business, financial condition or results of operations:

• We cannot assure that any acquired businesses will achieve anticipated revenues, earnings or cash flow.

• We may be unable to integrate acquired businesses successfully and realize anticipated economic, operational and other benefits in a timely manner, particularly if we acquire a business in a market in which we have limited or no current expertise, or with a corporate culture different from our own. If we are unable to integrate acquired businesses successfully, we could incur substantial costs and delays or other operational, technical or financial problems.

• Acquisitions could disrupt our ongoing business, distract management, divert resources and make it difficult to maintain our current business standards, controls and procedures.

• We may finance future acquisitions by issuing common stock for some or all of the purchase price. This could dilute the ownership interests of our stockholders. We may also incur additional debt or be required to recognize amortization expense related to goodwill and other intangible assets purchased in future acquisitions.

• We would be competing with other firms, many of which have greater financial and other resources, to acquire attractive companies. We believe this competition will increase, making it more difficult to acquire suitable companies on acceptable terms.

OUR INTERNATIONAL OPERATIONS AND EXPANSION INVOLVE FINANCIAL AND OPERATIONAL RISKS

The expansion of our international operations will require significant management attention and financial resources to establish additional foreign operations, hire additional personnel and recruit additional international resellers. Non-North American revenues accounted for 21%, 25%, and 19% of our total revenues in 2001, 2000, and 1999, respectively. To date, our products have been licensed outside North America primarily in Western Europe, South Africa, and Australia. We are also expanding our marketing efforts in Japan, Korea, China and Central and South America. We intend to continue to expand our international operations and enter additional international markets. Revenues from international expansion may be inadequate to cover the expenses of international expansion. In addition to foreign currency fluctuation risks described in the next risk factor, other risks inherent in our international business activities, in the countries in which we have licensed our products to date and in those countries in which we intend to expand, generally could include the following:

• economic and political instability;

• unexpected changes in foreign regulatory requirements and laws;

• tariffs and other trade barriers;

• timing, cost and potential difficulty of adapting our software products to the local language in those foreign countries that do not use the alphabet that English uses, such as Japan, Korea and China;

• lack of acceptance of our products in foreign countries;

• longer sales cycles and accounts receivable payment cycles;

• potentially adverse tax consequences; and

• restrictions on the repatriation of funds.

FLUCTUATIONS IN THE VALUE OF FOREIGN CURRENCIES COULD RESULT IN LOSSES

Our international revenues are generally denominated in U.S. Dollars, but our international expenses are generally denominated in local foreign currencies. Although foreign currency translation gains and losses have been immaterial to date, fluctuations in exchange rates between the U.S. Dollar and other currencies could have a material adverse effect on our business, financial condition or results of operations, and particularly on our operating margins. To date, we have minimally sought to hedge the risks associated with fluctuations in exchange rates, but we may more actively undertake to do so in the future. Any hedging techniques we implement in the future may not be successful. Exchange rate fluctuations could also make our products more expensive than competitive products not subject to these fluctuations, which could adversely affect our revenues and profitability in international markets.

OUR PRODUCTS COULD HAVE DEFECTS FOR WHICH WE ARE POTENTIALLY LIABLE AND WHICH COULD RESULT IN LOSS OF REVENUE, INCREASED COSTS OR LOSS OF OUR CREDIBILITY OR DELAY IN ACCEPTANCE OF OUR PRODUCTS IN THE MARKET

Our products, including components supplied by others, may contain errors or defects, especially when first introduced or when new versions are released. Despite internal product testing, we have in the past discovered software errors in some of our products after their introduction. Errors in new products or releases could be found after commencement of commercial shipments, and this could result in additional development costs, diversion of technical and other resources from our other development efforts, or the loss of credibility with current or future end-user customers. This could result in a loss of revenue or delay in market acceptance of our products, which could have a material adverse effect on our business, financial condition or results of operations.

Our license agreements with our end-user customers typically contain provisions designed to limit our exposure to potential product liability and some contract claims. However, not all of these agreements contain these types of provisions and, where present, these provisions vary as to their terms and may not be effective under the laws of some jurisdictions. A product liability, warranty, or other claim brought against us could have a material adverse effect on our business, financial condition or results of operations.

Because our solution currently consists of our software running on a Windows NT® server and voice processing boards, it is inherently more prone to performance interruptions for our end-user customers than traditional non-software based products. Performance interruptions at our end-user customer sites, most of which currently do not have back-up systems, could affect demand for our products or give rise to claims against us.

From time to time, we are also involved in certain legal proceedings in the ordinary course of conducting our business. While the ultimate liability pursuant to these actions cannot currently be determined, we believe these legal proceedings will not have a material adverse effect on our financial position.

We may not be able to obtain adequate financing to implement our strategy

Successful implementation of our strategy may require continued access to capital. If we do not generate sufficient cash from operations, our growth could be limited unless we are able to obtain capital through additional debt or equity financings. We cannot assure you that debt or equity financings will be available as required for acquisitions or other needs. Even if financing is available, it may not be on terms that are favorable to us or sufficient for our needs. If we are unable to obtain sufficient financing, we may be unable to fully implement our growth strategy.

OUR STOCK PRICE HAS BEEN AND COULD CONTINUE TO BE HIGHLY VOLATILE

Our stock price has been highly volatile. This volatility may be heightened because our industry is new and evolving, characterized by rapid technological change and susceptible to the introduction of new competing technologies or competitors.

Our stock price could continue to be highly volatile due to a number of factors, including but not limited to:

• actual or anticipated fluctuations in our operating results;

• announcements by us, our competitors or our end–user customers;

• changes in financial estimates of securities analysts or investors regarding us, our industry, our competitors or our end–user customers;

• technological innovations by others;

• the operating and stock price performance of other comparable companies or of our competitors or end–user customers;

• the low number of our shares typically traded in any trading session;

• the availability for future sale, or sales, of a substantial number of shares of our common stock in the public market; and

• general market or economic conditions.

In addition, the stock market has experienced significant price and volume fluctuations that have particularly affected the trading prices of equity securities of many technology companies, including us. These price and volume fluctuations often have been unrelated to the operating performance of the affected companies. In the past, following periods of volatility in the market price of a company’s securities, securities class action litigation has often been instituted against that company. This type of litigation, regardless of the outcome, could result in substantial costs and a diversion of management’s attention and resources, which could materially and adversely affect our business, financial condition or results of operations.

A CONTINUED DECLINE IN CAPITAL SPENDING COULD HAVE A MATERIAL ADVERSE EFFECT ON US

Our products typically represent substantial capital commitments by customers, involving a potentially long sales cycle. As a result, customer purchase decisions may be significantly affected by a variety of factors including trends in capital spending for telecommunications, enterprise software, market competition, and the availability or announcement of alternative technologies. Continued recent weakness in global economic conditions has resulted in many of our customers delaying and/or reducing their capital spending related to information systems. If the economy continues to be weak, demand for our products could decrease resulting in lower revenues and a decline in the overall rate of the our revenue levels.

Item 3. Quantitative and Qualitative Disclosures about Market Risk.

We develop products in the United States and sell licenses in North America, Europe, the Asia/Pacific region, South Africa, and Central and South America. As a result, our financial results could be affected by

various factors, including changes in foreign currency exchange rates or weak economic conditions in foreign markets. As most sales are currently made in U.S. dollars, a strengthening of the dollar could make our products less competitive in foreign markets. Additionally, as our business matures in foreign markets, we may offer our products and services in certain local currencies. As a result, we will be subject to foreign currency fluctuations which may have an adverse affect on the company.

We manage our interest rate risk by maintaining an investment portfolio with debt instruments of high credit quality and relatively short average maturities. We also manage interest rate risk by maintaining sufficient cash and cash equivalent balances such that we are typically able to hold our investments to maturity.

PART II. OTHER INFORMATION

Item 1. Legal Proceedings.

From time to time, the Company is also involved in certain legal proceedings in the ordinary course of conducting our business. While the ultimate liability pursuant to these actions cannot currently be determined, none is expected to be material to our results of operations, financial condition or cash flows.

Item 4. Submissions of Matters to Vote of Security Holders

We held our annual meeting of shareholders on May 21, 2002. At that meeting, our shareholders reelected Donald E. Brown, M.D. and Robert A. Compton as Directors of the Corporation to each serve a three year term and until his successor is elected and has qualified. The final results of the votes taken at the meeting were as follows:

	Votes For	Votes Against	Broker on-Votes	Abstentions
Election of Directors
Donald E. Brown, M.D.	13,198,013	—	—	674,456
Robert A. Compton,	13,862,157	—	—	10,312

Item 6. Exhibits and Reports on Form 8-K.

(a) Exhibits

10.17 (iii) Modification and /or Extension Agreement, dated April 29, 2002, between the Company and KeyBank

10.34 Termination Letter Agreement between the Company and Michael E. Ford, dated April 17, 2002.

99.1 Certification pursuant to 18 U.S.C Section 1350, Donald E. Brown, CEO

99.2 Certification pursuant to 18 U.S.C Section 1350, Keith A. Midkiff, CFO

(b) Reports on Form 8-K

No reports on Form 8-K were filed during the quarter covered by this Form 10-Q.

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

	Interactive Intelligence, Inc.
		(Registrant)

Date: August 13, 2002	By /s/ Keith A. Midkiff

	Keith A. Midkiff
	Chief Financial Officer, Secretary and Treasurer
	(Principal Financial Officer and Principal Accounting Officer)