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, 2004

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.)

7601 Interactive Way
Indianapolis, Indiana 46278
(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

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

Yeso No ý

The number of shares of common stock outstanding on July 30, 2004 was 15,871,832.

TABLE OF CONTENTS

PART I. FINANCIAL INFORMATION

Item 1.	Condensed Consolidated Balance Sheets as of June 30, 2004 (unaudited) and December 31, 2003

	Condensed Consolidated Statements of Operations for the three and six months ended June 30, 2004 and 2003 (unaudited)

	Condensed Consolidated Statement of Shareholders’ Equity for the six months ended June 30, 2004 (unaudited)

	Condensed Consolidated Statements of Cash Flows for the six months ended June 30, 2004 and 2003 (unaudited)

	Notes to Condensed Consolidated Financial Statements (unaudited)

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

Item 3.	Quantitative and Qualitative Disclosures About Market Risk

Item 4.	Controls and Procedures

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

SIGNATURES

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, 2004			December 31, 2003
	June 30, 2004			December 31, 2003
	(unaudited)
Assets
Current assets:
Cash and cash equivalents	$	15,006		$	12,461
Short-term investments	—			3,008
Account receivable, net of allowance for doubtful accounts of $303 in 2004 and $354 in 2003	8,483			8,956
Prepaid expenses	1,912			1,958
Other current assets	223			418
Total current assets	25,624			26,801
Property and equipment, net	4,770			5,857
Other assets, net	590			601
Total assets	$	30,984		$	33,259

Liabilities and Shareholders’ Equity
Current liabilities:
Line of credit	$	3,000		$	2,800
Accounts payable and accrued liabilities	4,490			4,544
Accrued compensation and related expenses	1,217			1,349
Deferred software revenues	6,057			8,745
Deferred services revenues	11,886			12,030
Total current liabilities	26,650			29,468
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; 15,857,938 issued and outstanding at June 30, 2004, 15,755,477 issued and outstanding at December 31, 2003	158			157
Additional paid-in capital	65,007			64,696
Accumulated other comprehensive income	87			280
Accumulated deficit	(60,918		)	(61,342		)
Total shareholders’ equity	4,334			3,791
Total liabilities and shareholders’ equity	$	30,984		$	33,259

See Notes to Condensed Consolidated Financial Statements

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,

	2004		2003			2004		2003
Revenues:
Software	$	7,257	$	5,772		$	14,250	$	14,393
Services	6,384		6,335			13,097		12,098
Total revenues	13,641		12,107			27,347		26,491
Cost of revenues:
Software	400		325			893		617
Services	2,775		3,254			5,630		6,440
Total cost of revenues	3,175		3,579			6,523		7,057
Gross profit	10,466		8,528			20,824		19,434
Operating expenses:
Sales and marketing	5,076		4,910			10,104		10,117
Research and development	3,258		3,472			6,536		6,967
General and administrative	1,722		1,356			3,593		2,812
Restructuring and other charges	85		2,690			101		3,138
Total operating expenses	10,141		12,428			20,334		23,034
Operating income (loss)	325		(3,900		)	490		(3,600		)
Interest income, net	25		43			32		96
Income (loss) before income taxes	350		(3,857		)	522		(3,504		)
Income taxes	46		43			98		96
Net income (loss)	$	304	$	(3,900	)	$	424	$	(3,600	)

Net income (loss) per share:
Basic	$	0.02	$	(0.25	)	$	0.03	$	(0.23	)
Diluted	0.02		(0.25		)	0.03		(0.23		)

Shares used to compute net income (loss) per share:
Basic	15,845		15,600			15,826		15,582
Diluted	16,735		15,600			16,716		15,582

See Notes to Condensed Consolidated Financial Statements

Interactive Intelligence, Inc.

Condensed Consolidated Statement of Shareholders’ Equity (unaudited)

(in thousands)

	Common Stock			Additional Paid-in Capital		Accum. Other Comprehensive Income			Accumulated Deficit			Total
	Common Stock
	Shares	Amount

Balances, December 31, 2003	15,755	$	157	$	64,696	$	280		$	(61,342	)	$	3,791

Issuances of common stock	47	—		149		—			—			149
Exercise of stock options	56	1		152		—			—			153
Amortization of deferred stock-based compensation	—	—		10		—			—			10
Comprehensive income:
Foreign currency fluctuation	—	—		—		(193		)	—			(193		)
Net income	—	—		—		—			424			424
Total comprehensive income	—	—		—		(193		)	424			231

Balances, June 30, 2004	15,858	$	158	$	65,007	$	87		$	(60,918	)	$	4,334

See Notes to Condensed Consolidated Financial Statements

Interactive Intelligence, Inc.

Condensed Consolidated Statements of Cash Flows (unaudited)

(in thousands)

	Six Months Ended June 30,
	Six Months Ended June 30,
	2004			2003
Operating activities:
Net income (loss)	$	424		$	(3,600	)
Adjustments to reconcile net income (loss) to net cash provided (used) by operating activities:
Depreciation	1,670			2,447
Amortization of deferred stock-based compensation	10			46
Loss on disposal of fixed assets	—			539
Changes in operating assets and liabilities:
Accounts receivable	473			1,943
Prepaid expenses	46			610
Other current assets	2			(10		)
Other assets	11			(21		)
Accounts payable and accrued liabilities	(54		)	1,422
Accrued compensation and related expenses	(132		)	(52		)
Deferred software revenues	(2,688		)	(2,814		)
Deferred services revenues	(144		)	1,505
Net cash provided (used) by operating activities	(382		)	2,015

Investing activities:
Purchases of property and equipment	(583		)	(2,412		)
Sales of available-for-sale investments	3,008			6,368
Net cash provided by investing activities	2,425			3,956

Financing activities:
Proceeds from line of credit, net	200			—
Proceeds from issuance of common stock	149			167
Proceeds from stock options exercised	153			2
Net cash provided by financing activities	502			169

Net increase in cash and cash equivalents	2,545			6,140
Cash and cash equivalents, beginning of period	12,461			5,913
Cash and cash equivalents, end of period	$	15,006		$	12,053

Cash paid for interest	$	14		$	6
Cash paid for taxes	4			2

See Notes to Condensed Consolidated Financial Statements

Interactive Intelligence, Inc.

Notes to Consolidated Financial Statements

(unaudited)

1. Description of Business and Basis of Presentation

Interactive Intelligence, Inc. (the “Company”) is a leading provider of software applications for contact centers and is leveraging that leadership position to provide mission critical voice over Internet protocol (VoIP) applications to enterprises. The Company sells into four distinct markets, all of whose needs are increasing for VoIP-based systems:

• Contact Centers

• Enterprise IP Telephony

• Unified Communications, and

• Self-service Automation.

The Company’s principal competitors are hardware vendors who offer proprietary approaches using a combination of phone systems, call distributors, voicemail systems, and interactive voice response (IVR) systems equipment. The Company offers a software solution based on Microsoft Windows that resides on a customer’s network and uses an open Session Initiation Protocol (SIP) for VoIP networking. This open approach typically results in lower overall costs for phone devices, system maintenance, and customer networking. The Company’s software applications are also pre-integrated into many popular business applications such as financial, customer relationship management (CRM) and enterprise resource planning (ERP) software, thereby automating and tracking business transactions to customer interactions. The Company is best known for its bundled suite of contact center applications that includes multi-media customer contact for phone calls, Web chat, Web callback, e-mail queuing, customer defined queues, and integrated speech recognition applications.

In June 2004, the Company released the next version of its product, version 2.3, which underlies the Customer Interaction Center (CIC), Enterprise Interaction Center (EIC) and other applications. This version addresses reliability and scalability of the applications and provides for simplified installation and maintenance of all of the Company’s software applications.

Principal operations of the Company commenced during 1997. The Company currently markets its software applications in: the Americas; Europe, Middle East and Africa (EMEA); and Australia and other Asia/Pacific countries (APAC). Besides its corporate headquarters in Indianapolis, Indiana, the Company has established wholly-owned subsidiaries in Australia, France, the Netherlands and the United Kingdom. In addition, the Company has branch offices in Canada, Germany, Hong Kong, Japan, Korea, Malaysia, Singapore and Sweden.

On July 1, 2004, the Company formed a wholly-owned subsidiary, Vonexus, Inc. (Vonexus), which is responsible for the development, marketing and distribution of the Company’s EIC application. EIC is the Company’s standards-based all-software IP PBX that is offered as part of a complete telephony solution for Microsoft-centric small and medium-sized businesses.

The accompanying unaudited financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America 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 accounting principles generally accepted in the United States of America 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, 2003 has been derived from the audited financial statements at that date but does not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements.

These financial statements should be read in conjunction with our audited consolidated financial statements for the year ended December 31, 2003, included in the Company’s Form 10-K for the year

ended December 31, 2003, filed with the Securities and Exchange Commission on March 25, 2004. 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 Income Per Common Share

Basic net income per share is calculated based on the weighted-average number of outstanding common shares in accordance with Financial Accounting Standards Board (FASB) Statement No. 128, Earnings per Share. Diluted net income 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 income per share (in thousands, except per share amounts):

	Three Months Ended June 30,					Six Months Ended June 30,
	Three Months Ended June 30,					Six Months Ended June 30,
	2004		2003			2004		2003

Net income (loss) (A)	$	304	$	(3,900	)	$	424	$	(3,600	)

Weighted average outstanding shares of common stock (B)	15,845		15,600			15,826		15,582
Dilutive effect of options to purchase common stock	890		—			890		—
Common stock and common stock equivalent shares (C)	16,735		15,600			16,716		15,582

Net income (loss) per share:
Basic (A/B)	$	0.02	$	(0.25	)	$	0.03	$	(0.23	)
Diluted (A/C)	0.02		(0.25		)	0.03		(0.23		)

The Company’s calculation of diluted net income per share for the three months and six months ended June 30, 2004 excludes options to purchase 1.2 million shares of common stock with exercise prices ranging from $5.79 to $50.50 as their effect would be antidilutive. The Company’s calculation of diluted net loss per share for the three and six months ended June 30, 2003 excludes all potential common shares as the effect would be antidilutive.

3. Stock-Based Compensation

The Company applies the intrinsic-value-based method of accounting prescribed by Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations including FASB Interpretation No. 44, Accounting for Certain Transactions involving Stock Compensation, an interpretation of APB Opinion No. 25, to account for its fixed-plan stock options. Under this method, compensation expense is recorded on the date of grant only if the current market price of the underlying stock exceeds the exercise price. FASB Statement No. 123, Accounting for Stock-Based Compensation and FASB Statement No. 148, Accounting for Stock-Based Compensation – Transition and Disclosure - an amendment of FASB Statement No. 123, established accounting and disclosure requirements using a fair-value-based method of accounting for stock-based employee compensation plans. As permitted by existing accounting standards, the Company has elected to continue to apply the intrinsic-value-based method of accounting described above, and has adopted only the disclosure requirements of FASB Statement No. 123, as amended.

For purposes of pro forma disclosures, the estimated fair value of the options is amortized to expense on a straight-line basis over the options’ vesting period. The table below illustrates the effect on net income (loss) and net income (loss) per share if the Company had applied the fair value recognition provisions of FASB Statement No. 123 to stock-based employee compensation (in thousands except per share amounts).

	Three Months Ended June 30,						Six Months Ended June 30,
	Three Months Ended June 30,						Six Months Ended June 30,
	2004			2003			2004			2003

Net income (loss), as reported	$	304		$	(3,900	)	$	424		$	(3,600	)
Add: Stock-based compensation expense included in reported net income, net of related tax effects	7			23			10			46
Deduct: Total stock-based compensation expense determined under fair value based method for all awards, net of related tax effect	(855		)	(1,381		)	(1,607		)	(2,770		)
Pro forma net loss	$	(544	)	$	(5,258	)	$	(1,173	)	$	(6,324	)

Net income (loss) per share:
Basic – as reported	$	0.02		$	(0.25	)	$	0.03		$	(0.23	)
Diluted – as reported	$	0.02		$	(0.25	)	$	0.03		$	(0.23	)
Basic – pro forma	$	(0.03	)	$	(0.34	)	$	(0.07	)	$	(0.41	)
Diluted – pro forma	$	(0.03	)	$	(0.34	)	$	(0.07	)	$	(0.41	)

4. Concentration of Credit Risk

One reseller represented 15% of accounts receivable as of June 30, 2004 and one customer represented approximately 10% of total revenues for the six months ended June 30, 2003.

5. Contingencies

From time to time the Company has received claims from competitors and other technology providers claiming that the Company’s technology infringes their respective proprietary rights. One such claim has resulted in a legal proceeding being filed against the Company, which is described below. In addition, the Company is involved in certain legal proceedings in the ordinary course of conducting its business. The Company believes these claims and legal proceedings can be resolved without a material adverse effect on its business, financial condition or results of operations; however, the Company cannot provide assurance as to the outcome. Litigation in general, and intellectual property litigation in particular, can be expensive and disruptive to normal business operations. Moreover, the results of complex legal proceedings are difficult to predict.

In 2002, the Company received a letter from a consulting firm that 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 that the Company has infringed on the technology provider’s propriety rights and therefore feels that a licensing agreement between the Company and the technology provider is appropriate. The Company believes that it did not infringe on the technology provider’s proprietary rights; however, because of the cost of defending such a matter in court, the Company did offer a settlement. The technology provider has not accepted the Company’s offer of settlement. The Company does not believe a settlement is probable and the term over which a settlement would be recognized is uncertain. The Company may be required to defend its position in a court of law should a lawsuit be filed. Because of the facts presented above, the Company has not recorded an accrual for any settlement in this matter. The Company cannot provide assurance as to the outcome.

In 2002, the Company received a letter from one of its resellers requesting indemnification related to a request that the reseller had received for indemnification from a customer. The customer had received a letter from a third party indicating that the customer may be infringing patents held by the third party. To date, the Company’s patent counsel has not determined the validity or the applicability of these patents as they relate to the Company’s products or whether the reseller is entitled to indemnification. The Company believes that this matter can be resolved without a material adverse effect on its business, financial condition or results of operations; however, the Company cannot provide assurance as to the outcome.

On September 30, 2003, Recursion Software, Inc. filed suit in Dallas County Court in Dallas, Texas against the Company alleging breach of contract and money due under claims of quantum meruit, unjust enrichment and infringement. Recursion claims that the Company incorporated Recursion software into one of its products in breach of the underlying license. No dollar amount has been stated in the action. The Company believes that it has strong defenses to the claims and intends to vigorously defend against the action. The Company believes that this matter can be resolved without a material adverse effect on its business, financial condition or results of operations; however, the Company cannot provide assurance as to the outcome.

In 2002, the Company received a notification from the French government as a result of a tax audit that had been conducted encompassing the years 1998, 1999, 2000 and 2001. These assessments claim various taxes are owed related to Value Added Tax (VAT) and corporation taxes in addition to what has previously been paid and accrued. As of June 30, 2004, the assessment related to VAT was approximately $2.8 million and the assessment related to corporation taxes was approximately $366,000. The Company’s tax counsel has assessed the possibility of the Company paying the assessment related to VAT as remote and the assessment related to corporation taxes as reasonably possible; the Company has not accrued for these amounts. The Company is appealing the assessments, but cannot assure you that these matters will be resolved without litigation or that it will not have to pay some or all of the assessments.

6. Restructuring Charges

In February 2003, the Company announced its plan to downsize and reorganize resources in EMEA. The French office was significantly affected, with most positions moved or eliminated. The Company determined that the severance payments and related legal fees incurred qualified as restructuring costs in accordance with FASB Statement No. 146, Accounting for Costs Associated with Exit or Disposal Activities.

Effective April 1, 2003, the Company moved its worldwide headquarters to a new building in Indianapolis, Indiana and all Indianapolis-based employees, equipment and furniture were relocated to the new facility. The majority of the lease on the previous headquarters has expired, however the Company continues to owe lease payments on a small portion of the previous headquarters through February 12, 2005. The Company determined that the remaining lease payments as of April 1, 2003 for the previous headquarters, net of sublease income, qualified as an exit cost and was recognized in accordance with SFAS 146 as restructuring charges. The Company does not anticipate additional restructuring charges related to the relocation of its worldwide headquarters.

The Company has ten former employees from its French office with whom it has not reached agreement regarding severance. The Company has recorded a liability for the estimated severance for those employees in accordance with FASB Statement No. 146. The Company could incur additional expenses related to these employees for legal fees and for additional severance costs when a settlement is reached.

The Company recognized restructuring charges in accordance with FASB Statement No. 146 of $85,000 and $2.7 million for the three months ended June 30, 2004 and 2003, respectively, and $101,000 and $3.1 million for the six months ended June 30, 2004 and 2003, respectively.

A summary of the beginning accrued restructuring charges, expensed amount, cash payments and the ending accrued restructuring charges for the six months ended June 30, 2004 is presented below (in thousands).

	Beginning Balance		Expense		Cash Payments			Ending Balance
	Beginning Balance		Expense		Cash Payments			Ending Balance

EMEA restructuring	$	549	$	101	$	(207	)	$	443
Headquarters	267		—		(261		)	6
Total	$	816	$	101	$	(468	)	$	449

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 involve risks and uncertainties which may cause actual results to differ materially from those predicted in the forward-looking statements. Forward-looking statements can often 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 that may affect our future 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, 2003.

Overview

We are a leading provider of software applications for contact centers and hope to leverage that leadership position to provide mission critical VoIP applications to enterprises. Our customers are in a wide variety of fields including financial institutions, government, healthcare and retail, among others. We are a global software provider with presence in: the Americas; Europe, Middle East and Africa (EMEA); and Australia and other Asia/Pacific countries (APAC).

Financial Highlights

In the initial years after we began licensing our software applications, our revenue growth was substantial. In 2002 and 2003, we saw a decrease in worldwide spending on technology given the global economic slowdown, and as a result, our revenue growth has diminished.

We believe that during the economic downturn and resulting decrease in technology spending, it became harder to market our products to new customers. Companies delayed changes to their systems and continued to use technology that they had in place. However, we believe that once companies have implemented our software and the personnel at these companies experience the capabilities and efficiencies of our software, these companies are increasing their technology spending for our software. Future licensing to new customers is dependent on the economy and whether companies will allocate their resources to upgrade their systems.

Revenues recognized in the three months ended June 30, 2004 increased over $1.5 million from revenues for the three months ended June 30, 2003. Total revenues for the six months ended June 30, 2004 increased $856,000 over the six months ended June 30, 2003. Software revenues of $7.3 million for the three months ended June 30, 2004 were up nearly $1.5 million over the three months ended June 30, 2003. Beginning in the first quarter of 2004, we began offering perpetual licenses to our new customers and therefore the recognition of revenue on new contracts signed in 2004 was accelerated compared to how revenue was recognized under annually renewable licenses in 2003.

The information below shows our total revenues and percentage growth from the previous year since sales commenced (revenues in millions).

Year	Revenues		% Growth
2004 (through June 30, 2004)	$	27.3	3	%(1)
2003	51.5		8
2002	47.8		0
2001	47.9		76
2000	27.3		43
1999	19.1		112

(1) Percent growth shown is for the six months ended June 30, 2004 compared to the six months ended June 30, 2003.

Operating expenses for the three and six months ended June 30, 2004 decreased $2.3 million and $2.7 million, respectively, compared to the three and six months ended June 30, 2003. These decreases were primarily due to restructuring charges recognized in 2003 related to the reorganization of our European operations and the relocation of our world-wide headquarters and also due to a slight decrease in research and development expenses in 2004 compared to 2003 related to a slight reduction in headcount and lower depreciation expense. These decreases were partially offset by an increase in general and administrative expenses in 2004 due mostly to higher legal expenses related to the hiring of a general counsel and increased efforts to resolve litigation and other claims against us.

We had approximately $15.0 million of cash and cash equivalents as of June 30, 2004. We had borrowings under a line of credit of $3.0 million as of June 30, 2004, which has since been repaid in full. We believe that as our revenues grow, the collection of our accounts receivable improves and our expenses remain controlled, we will increase our liquidity and position ourselves for growth in the future. If revenues remain stagnant or decrease, or if we are unable to collect our outstanding account receivable balances from our customers, our liquidity position may weaken, which would result in the need to raise capital, either through the capital markets or debt financings.

We have formed a new subsidiary, Vonexus, on July 1, 2004. Vonexus will be focused on selling a complete IP-based phone system, including hardware, to Microsoft-based small and medium-sized businesses. As a result of this new market focus, we expect to recognize additional sales and marketing expenses in the third and fourth quarters of 2004. We may also incur additional costs of revenues related to hardware costs and, as a consequence, if Vonexus sales become significant our gross profits as a percentage of revenues may decline.

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, 2004 and 2003 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,
	Three Months Ended June 30,				Six Months Ended June 30,
	2004		2003		2004		2003
Revenues:
Software	53	%	48	%	52	%	54	%
Services	47		52		48		46
Total revenues	100		100		100		100
Cost of revenues:
Software	3		3		3		2
Services	20		27		21		24
Total cost of revenue	23		30		24		26
Gross profit	77		70		76		74
Operating expenses:
Sales and marketing	37		41		37		38
Research and development	24		29		24		26
General and administrative	13		11		13		11
Restructuring and other charges	1		22		—		12
Total operating expenses	75		103		74		87
Operating income (loss)	2		(33	)	2		(13	)
Interest income, net	—		—		—		—
Income (loss) before income taxes	2		(33	)	2		(13	)
Income taxes	—		—		—		—
Net income (loss)	2	%	(33	)%	2	%	(13	)%

Comparison of Three and Six Months Ended June 30, 2004 and 2003

Revenues

Software Revenues

	Three Months Ended June 30,						Six Months Ended June 30,
	Three Months Ended June 30,						Six Months Ended June 30,
	2004			2003			2004			2003
				($ in thousands)
Software revenues	$	7,257		$	5,772		$	14,250		$	14,393
Change from prior year	26		%	(25		)%	(1		)%	(6		)%
Percentage of total revenues	53		%	48		%	52		%	54		%

The increase in software revenues and percent of software revenues to total revenues for the three months ended June 30, 2004 compared to the three months ended June 30, 2003, was related primarily to an increase in the percentage of perpetual license agreements we recognized in 2004. Beginning in the first quarter of 2004, we began offering perpetual licenses to our new customers and therefore the recognition of revenue on new contracts signed in 2004 was accelerated compared to how revenue was recognized under annually renewable licenses in 2003. Some customers prefer a perpetual license; therefore, the decision to offer customers perpetual licenses was a part of other actions designed to improve our customer licensing process and may result in the acceleration of revenue recognition. Forty-four percent of the software revenues recognized in the three months ended June 30, 2004 were related to perpetual license agreements compared to 8% of the software revenues in the three months ended June 30, 2003.

Entering into more perpetual license agreements had a similar effect on software revenues for the six months ended June 30, 2004 compared to software revenues for the six months ended June 30, 2003; however, we recognized approximately $3 million of software revenues in the first three months of 2003 related to a perpetual license agreement with one customer. Forty-one percent of the software revenues recognized in the six months ended June 30, 2004 were related to perpetual license agreements compared to 22% of the software revenues in the six months ended June 30, 2003 (including the one large perpetual agreement during the first three months of 2003).

Services Revenues

	Three Months Ended June 30,						Six Months Ended June 30,
	Three Months Ended June 30,						Six Months Ended June 30,
	2004			2003			2004			2003
				($ in thousands)
Services revenues	$	6,384		$	6,335		$	13,097		$	12,098
Change from prior year	1		%	43		%	8		%	38		%
Percentage of total revenues	47		%	52		%	48		%	46		%

Services revenues remained fairly constant for the three months ended June 30, 2004 compared to the three months ended June 30, 2003. Support and maintenance revenues increased, due to increases in our growing installed base of customers and related payments of annual license renewal fees and ongoing maintenance from perpetual licenses, but were offset by a decrease in royalty income related to third party hardware sales and a decrease in professional services revenues.

The increase in services revenues for the six months ended June 30, 2004 compared to the six months ended June 30, 2003 was primarily due to increases in our growing installed base of customers and related payments of annual license renewal fees and ongoing maintenance from perpetual licenses. As we sign and install new customers, our services revenues should grow, if existing customers continue to renew licenses and pay for maintenance on our software applications. The percent of services revenues to total revenues grew due to the decrease in software revenues (as described above) coupled with the increasing services revenues.

Cost of Revenues

	Three Months Ended June 30,						Six Months Ended June 30,
	Three Months Ended June 30,						Six Months Ended June 30,
	2004			2003			2004			2003
				($ in thousands)
Cost of revenues:
Software	$	400		$	325		$	893		$	617
Services	2,775			3,254			5,630			6,440
Total cost of revenues	$	3,175		$	3,579		$	6,523		$	7,057
Change from prior year	(11		)%	17		%	(8		)%	11		%
Software costs as a % of software revenues	6		%	6		%	6		%	4		%
Services costs as a % of services revenues	43		%	51		%	43		%	53		%

Costs of software consist primarily of product and software 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 can fluctuate depending on which software applications are licensed to our customers, and the third party technology, if any, which is licensed. The increase in the software costs for the three and six months ended June 30, 2004 compared to the three and six months ended June 30, 2003 was due to increased royalties for third party software.

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 customers. The decrease in costs of services and costs of services as a percent of services revenues for the three and six months ended June 30, 2004 compared to June 30, 2003 was a result of our focus on cost control, which resulted in a decrease in headcount in this area, as well as a reduction in our utilization of outside sources to provide professional services for our customers.

Gross Profit

	Three Months Ended June 30,						Six Months Ended June 30,
	Three Months Ended June 30,						Six Months Ended June 30,
	2004			2003			2004			2003
				($ in thousands)
Gross profit	$	10,466		$	8,528		$	20,824		$	19,434
Change from prior year	23		%	(6		)%	7		%	10		%
Percentage of total revenues	77		%	70		%	76		%	74		%

Gross profit and gross profit as a percentage of total revenues increased for the three and six months ended June 30, 2004 compared to June 30, 2003. For the three months ended June 30, 2004 compared to June 30, 2003, this increase was the result of an increase in software revenues resulting from more perpetual license agreements and a decrease in cost of services due to a reduction in headcount and reduction in the utilization of outside services. For the six months ended June 30, 2004 compared to June 30, 2003, the increase was related to an increase in services revenues resulting from our growing customer base, and a decrease in cost of services due to a reduction in headcount and reduction in the utilization of outside services.

Operating Expenses

Sales and Marketing

	Three Months Ended June 30,						Six Months Ended June 30,
	Three Months Ended June 30,						Six Months Ended June 30,
	2004			2003			2004			2003
				($ in thousands)
Sales and marketing expenses	$	5,076		$	4,910		$	10,104		$	10,117
Change from prior year	3		%	(5		)%	0		%	(6		)%
Percentage of total revenues	37		%	41		%	37		%	38		%
Percentage of software revenues	70		%	85		%	71		%	70		%

Sales and marketing expenses are comprised primarily of compensation expense and travel, entertainment and other related expenses, which have remained fairly consistent in the periods presented above. As described previously under Financial Highlights, we expect sales and marketing expenses to increase during the third and fourth quarters of 2004 related to the additional costs for Vonexus, a newly formed subsidiary.

Research and Development

	Three Months Ended June 30,						Six Months Ended June 30,
	Three Months Ended June 30,						Six Months Ended June 30,
	2004			2003			2004			2003
				($ in thousands)
Research and development expenses	$	3,258		$	3,472		$	6,536		$	6,967
Change from prior year	(6		)%	(6		)%	(6		)%	(8		)%
Percentage of total revenues	24		%	29		%	24		%	26		%

Research and development expenses are comprised primarily of compensation expenses. Research and development expenses decreased slightly for the three and six months ended June 30, 2004 compared to June 30, 2003 due to a small decrease in headcount and depreciation.

General and Administrative

	Three Months Ended June 30,						Six Months Ended June 30,
	Three Months Ended June 30,						Six Months Ended June 30,
	2004			2003			2004			2003
				($ in thousands)
General and administrative expenses	$	1,722		$	1,356		$	3,593		$	2,812
Change from prior year	27		%	(2		)%	28		%	(2		)%
Percentage of total revenues	13		%	11		%	13		%	11		%

General and administrative expenses are comprised of compensation expense and non-allocable expenses including bad debt, legal and other professional service fees. General and administrative expenses increased for the three and six months ended June 30, 2004 compared to June 30, 2003. This increase is the result of higher legal expenses, including the hiring of a general counsel in the third quarter of 2003 and an increase in outside legal expenses due to increased efforts to resolve litigation and other claims against the Company. See Note 5 of Notes to Condensed Consolidated Financial Statements.

Restructuring and Other Charges

	Three Months Ended June 30,						Six Months Ended June 30,
	Three Months Ended June 30,						Six Months Ended June 30,
	2004			2003			2004			2003
				($ in thousands)
Restructuring and other charges	$	85		$	2,690		$	101		$	3,138
Change from prior year	97		%	294		%	97		%	360		%
Percentage of total revenues	1		%	22		%	0		%	12		%

Restructuring and other charges decreased significantly for the three and six months ended June 30, 2004 compared to June 30, 2003. During the three months ended June 30, 2003, we incurred $2.7 million in charges related to the restructuring of our European operations and relocation of our worldwide headquarters. In February 2003, we announced our plan to downsize and reorganize our resources in EMEA. The French office was most affected with most of the French employees terminated or relocated.

We recognized these expenses in accordance with FASB Statement No. 146, Accounting for Costs Associated with Exit or Disposal Activities (SFAS 146). The restructuring and other expenses recognized in the three and six months ended June 30, 2004 were legal fees incurred during the period related to the EMEA reorganization. We expect to incur some additional expenses related to the restructuring of international operations in 2004; however, at this time, we do not expect the amount to be significant. See Note 6 of Notes to Condensed Consolidated Financial Statements. Although we do not currently believe that we will need to further reduce staff, the state of the economy and resulting technology spending by businesses, among other factors, could result in further reductions.

Additionally, we moved our worldwide headquarters to a new building in Indianapolis, Indiana effective April 1, 2003. Because we continued to owe lease payments on the previous headquarters, we determined that those lease payments, net of sublease income, qualified as exit costs in accordance with SFAS 146. We recognized a total of $1.6 million of restructuring and other charges for the three months ended June 30, 2003 related to this relocation.

Interest Income, Net

The majority of interest income, net is made up of interest earned from investments and interest-bearing cash accounts. Interest expense, which is not material for any periods reported, is also included in interest income, net. We have experienced decreased interest earnings as shown below.

	Three Months Ended June 30,						Six Months Ended June 30,
	Three Months Ended June 30,						Six Months Ended June 30,
	2004			2003			2004			2003
				($ in thousands)
Cash, cash equivalents and short-term investments (average)	$	15,065		$	15,857		$	15,238		$	15,194
Interest income	26			48			46			107
Return on investment (annual)	0.7		%	1.2		%	0.6		%	1.4		%

The decrease in net interest income for the three and six months ended June 30, 2004 compared to June 30, 2003 was related mainly to a decrease in interest rates, an increase in interest expense and to the mix of investments. In 2003, we utilized short-term investments in our investing strategy, while in 2004, all cash was held in cash and cash equivalents accounts. Cash and cash equivalents earn a lower rate of return than short-term investments. We opted to invest in this more liquid mix of investments in 2004 in order to ensure the availability of our cash.

Liquidity and Capital Resources

In 1999 we raised cash through an initial public offering that provided net proceeds of $34.9 million. In 2001 we received an equity investment that yielded $15 million in cash. In addition, we generate cash from the collections we receive related to licensing our application software and from annual license renewals, maintenance and support and other services revenues. We also have in place a $3 million line of credit, which was fully utilized as of June 30, 2004 and repaid in full subsequent to June 30, 2004. We use cash primarily for paying our employees (including salaries, commissions, benefits and severance), leasing office space, reimbursing travel expenses, paying insurance premiums and paying vendors for services rendered and supplies purchased. In addition, we purchase property and equipment, including furnishing our new worldwide headquarters and in-house technology purchases.

We determine liquidity by combining cash and cash equivalents and short-term investments net of our line of credit borrowings as shown in the table below. Our total liquidity position decreased as of June 30, 2004 compared with our position as of December 31, 2003. In general this decrease was due to the timing

of our accounts receivable collections. We believe that our current liquidity position, when combined with our anticipated cash flows from operations, will be sufficient to satisfy our cash needs over the next 12 months. If cash flows from operations are less than anticipated or we have additional cash needs (such as an unfavorable outcome in legal proceedings), our liquidity may not be sufficient to cover our needs. In this case, we may be forced to raise additional capital, either through the capital markets or debt financings. We may not be able to receive favorable terms in raising this capital.

	June 30, 2004			December 31, 2003
	June 30, 2004			December 31, 2003
	($ in thousands)
Cash and cash equivalents	$	15,006		$	12,461
Short-term investments	—			3,008
Line of credit	(3,000		)	(2,800		)
Liquidity, net	$	12,006		$	12,669

Our operating activities resulted in a net cash outflow of $382,000 for the six months ended June 30, 2004 compared with a net cash inflow of $2.0 million for the six months ended June 30, 2003. These cash results from our operating activities were affected by accounts receivable fluctuations (the balance decreased $473,000 for the six months ended June 30, 2004 compared to a decrease of $1.9 million for the six months ended June 30, 2003), accounts payable fluctuations (the balance remained consistent for the six months ended June 30, 2004 compared to an increase of $1.4 million for the six months ended June 30, 2003) and changes in deferred revenues (which decreased $2.8 million for the six months ended June 30, 2004 compared to a decrease of $1.3 million for the six months ended June 30, 2003).

The amount that we report as cash and cash equivalents or as temporary investments fluctuates depending on investing practices in each period. Purchases of short-term investments are reported as a use of cash and the related receipt of proceeds upon maturity of the investment is reported as a source of cash.

We purchased property and equipment with a cost of $583,000 and $2.4 million in the six months ended June 30, 2004 and 2003, respectively. We moved our worldwide headquarters in the second quarter of 2003.

The net increase in our borrowings on our line of credit provided cash of $200,000 for the six months ended June 30, 2004.

Critical Accounting Policies and Estimates

We believe there are three accounting policies that are important to understanding our historical and future performance, as these policies affect the reported amounts of revenues and expenses and are the more significant areas involving management’s judgments and estimates. These critical accounting policies and estimates relate to revenue recognition, the allowance for doubtful accounts receivable and research and development. These policies, and our procedures related to these policies, are described below.

Sources of Revenues and Revenue Recognition Policy

We generate software revenues from licensing the right to use our software applications and generate services revenues primarily from annual renewal fees, annual maintenance fees, educational services and professional services. We believe both of these sources of revenues are critical to our financial statements because of their materiality to our statements as a whole and because of the judgment required in determining if revenue recognition criteria have been met.

Software Revenues

Our software license agreements are either annually renewable or perpetual. For any revenues to be recognized from a software license agreement, the following criteria must be met:

• persuasive evidence of an arrangement exists;

• the fee is fixed or determinable;

• collection is probable; and

• delivery has occurred.

For an annually renewable software license agreement, upon meeting the revenue recognition criteria above, we recognize a majority of the initial license fees under these agreements as software revenues ratably over the initial license period, which is generally 12 months, and the remainder of the initial license fees are recognized as services revenues over the same time period.

For a perpetual software license agreement, upon meeting the revenue recognition criteria above, we immediately recognize as software revenues the amount of initial license fees if sufficient vendor specific objective evidence exists to support allocating a portion of the total fee to the undelivered elements of the arrangement. If sufficient vendor specific objective evidence of the fair value of the undelivered elements does not exist, we recognize the initial license fee as software revenues ratably over the initial term of the maintenance agreement, which is generally 12 months.

Services Revenues

Services revenues are recognized for annually renewable software license agreements and perpetual software license agreements. For annually renewable software license agreements, the allocation of the initial order between software revenues and services revenues is based on an average of actual renewal fee rates. After the initial license period, our customers may renew their license agreement for an additional period, typically 12 months, by paying a renewal fee. Under perpetual software license agreements, we recognize initial annual maintenance fees based on actual renewal fee rates as services revenues ratably over the post-contract maintenance period, which is typically 12 months beginning at the date support is deemed to commence.

We also generate services revenues from other services that we provide to our resellers and customers. These additional services revenues include fees for educational services and professional services. Revenues from educational services, which consist of training courses for resellers and customers, and professional services, which include implementing and customizing our products for a customer, are typically recognized as the related services are performed.

Allowance for Doubtful Accounts Receivable

We adjust our allowance for doubtful accounts for each reporting period based on a detailed analysis of our accounts receivable at the end of that period. In estimating the allowance for doubtful accounts, we primarily consider the age of the reseller’s or customer’s receivable and also consider the creditworthiness of the reseller or customer, the economic conditions of the customer’s industry, and general economic conditions, among other factors. If payment is not made timely, we contact the customer or reseller to try to obtain payment. If this is not successful, we institute other collection practices such as generating collection letters, involving our sales representatives, involving a third party collection agency and ultimately terminating the customer’s license(s) and/or the customer’s and reseller’s access to future upgrades, licenses and customer support. Once all collection efforts are exhausted, the receivable is written off against the allowance for doubtful accounts.

Research and Development

Research and development expenditures are generally expensed as incurred. Based on our product development process and technological feasibility, the date at which capitalization of development costs may begin is established upon completion of a working model. Costs incurred between completion of the working model and the point at which the product is ready for general release have been insignificant. Through June 30, 2004, all research and development costs have been expensed.

Factors that may affect our future operating results are set forth below:

THE OVERALL ECONOMIC CLIMATE MAY BE WEAK

Our products typically represent substantial capital commitments by customers and involve a potentially long sales cycle. As a result, customer purchase decisions may be significantly affected by a variety of factors, including general economic trends in the allocation of capital spending budgets to communication software, services and systems, lengthened sales cycles, customer approval processes, and market conditions, which have resulted in many of our customers delaying and/or reducing their capital spending related to information systems. If the economy is weak, demand for our products could decrease, resulting in lower revenues.

WE HAVE HISTORICALLY INCURRED LOSSES AND WE MAY NOT SUSTAIN PROFITABILITY

Since inception, the first quarter of 2003 and the first two quarters of 2004 were the only quarters we have been profitable. We incurred net income of $424,000 in the six months ended June 30, 2004 and net losses of $5.9 million, $7.7 million and $11.0 million for the years ended December 31, 2003, 2002 and 2001, respectively. At June 30, 2004, we had accumulated net losses since inception of $60.9 million. We intend to continue to make significant investments in our research and development, marketing, services and sales operations. Certain of these expenses will precede generation of revenues. As a result, we may continue to experience losses and/or negative cash flow from operations in future quarters.

OUR QUARTERLY OPERATING RESULTS HAVE VARIED SIGNIFICANTLY

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 if or when our potential customers will place orders and finalize licenses, and because it is difficult to predict the mix of annually renewable licenses and perpetual licenses in a quarter, we cannot accurately forecast our licensing activity, our revenues and our operating results for future quarters. We recognize revenues from different licenses over different periods depending on the satisfaction of the requirements of relevant accounting literature, including AICPA Statement of Position 97-2, Statement of Position 98-9, SEC Staff Accounting Bulletin (SAB) 101, and all related AICPA Technical Practice Aids (5100.38 - 5100.76). As a result, our quarterly revenues and operating results depend on many factors, including the type of license, the size, quantity and timing of orders received for our products during each quarter, the delivery of the related software and our expectations regarding collection. 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 customers’ decisions to license our products. Since a large portion of our operating expenses, including salaries and rent, is fixed and difficult to reduce or modify in a short time period, our business, financial condition or results of operations could be materially adversely affected if revenues do not meet our expectations.

Our limited number of products, changes in pricing policies, the timing of development completion, and 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 VARIABILITY OF QUARTERLY OPERATING RESULTS

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. The lengthy sales cycle also makes it difficult for us to forecast product license revenues. Because of the unique characteristics of our products, our prospective 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 that we license or of our products and capabilities. For this reason, we must provide a significant level of education to prospective customers about the use and benefits of our products, which can cause potential customers to take many months to make these decisions. As a result, sales cycles for 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 customer orders depends on a number of other factors over which we have little or no control, including:

• a customer’s budgetary constraints;

• the timing of a customer’s budget cycles;

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

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

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 continue to expand internationally.

OUR INABILITY TO SUCCESSFULLY MANAGE 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 have 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 applications is highly competitive and, because there are relatively low barriers to entry in the software market, we expect competition to increase in the future. In addition, because our industry is 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 and telecommunications 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 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 continuing to rely heavily on such partners in the future. We are still developing 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 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 and prevent us from attracting new customers.

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

Our products currently run only on Microsoft Windows operating systems. In addition, our products use other Microsoft 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 software applications and to develop new software applications on a timely basis. Our software applications will have to continue to achieve market acceptance, maintain technological competitiveness and meet an expanding range of customer requirements. As a result of the complexities

inherent in our applications, major new applications and application enhancements require long development and testing periods. We may not be successful in developing and marketing, on a timely and cost effective basis, application enhancements or new software applications that respond to technological change, evolving industry standards or customer requirements. We may also experience difficulties that could delay or prevent the successful development, introduction or marketing of application enhancements, and our new applications and application enhancements may not achieve market acceptance. Significant delays in the general availability of new releases of our software applications or significant problems in the installation or implementation of new releases of our applications 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 FINANCIAL RESULTS AND GROWTH PROSPECTS

If the demand for interaction management software of the type we license does not grow within each of our four targeted markets, our financial results and ability to grow our business could be materially adversely affected. All of our revenues have been generated from licenses of our Interaction Center Platform 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 customers in significantly larger numbers than we have historically achieved.

IF OUR 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 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 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.

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 patents, licensing and other agreements with consultants, suppliers, strategic and OEM partners, resellers and customers, and employee and third-party non-disclosure agreements. These laws and agreements provide only limited protection of our proprietary rights. 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. 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

Third parties have claimed or may in the future 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 additional infringement claims. See Note 5 of Notes to the Condensed Consolidated Financial Statements for a description of contingencies.

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 RETAIN AND RECRUIT 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 other key personnel could have a material adverse effect on our business, financial condition or results of operations. 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.

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

In the future we may pursue 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 expense related to intangible assets recorded in future acquisitions.

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

OUR INTERNATIONAL OPERATIONS INVOLVE FINANCIAL AND OPERATIONAL RISKS

Our international operations require significant management attention and financial resources to establish and operate, including hiring appropriate personnel and recruiting effective international resellers. Non-North American revenues accounted for 20%, 13%, 19% and 22% of our total revenues for the six months ended June 30, 2004 and the years ended December 31, 2003, 2002, and 2001, respectively. We have marketing efforts in the Americas, EMEA and APAC. To date, our products have been licensed outside North America primarily in Western Europe, South Africa, and Australia. We intend to continue to emphasize our international operations and we may enter additional international markets. Revenues from international operations may be inadequate to cover the expenses of those operations. In addition to foreign currency fluctuation risks, other risks inherent in our international business activities may 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;

• restrictions on the repatriation of funds;

• acts of terrorism; and

• increased government regulations related to increasing or reducing business activity in various countries.

FLUCTUATIONS IN THE VALUE OF FOREIGN CURRENCIES COULD RESULT IN LOSSES

Our international revenues are generally denominated in U.S. dollars with the exception of some European resellers and customers located in countries who have adopted the Euro as their official currency. 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 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 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.

Performance interruptions in our products could also affect demand for our products or give rise to claims against us.

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 and could continue to be highly volatile due to a number of factors, including:

• actual or anticipated fluctuations in our operating results;

• announcements by us, our competitors or our customers;

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

• technological innovations by others;

• the operating and stock price performance of other comparable companies or of our competitors;

• 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.

This risk 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.

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.

OUR COMMON STOCK IS SUBJECT TO VARIOUS LISTING REQUIREMENTS

The various markets operated by The NASDAQ Stock Market have quantitative maintenance criteria for continued listing of common stock. We may be delisted from one or more NASDAQ markets if we fail to comply with the criteria. While we believe that we currently meet criteria for listing on a market operated by The NASDAQ Stock Market, we can offer no assurance that our common stock will continue to meet the various criteria for continued listing on any market operated by The NASDAQ Stock Market.

Any delisting may result in a reduction in the liquidity of our common stock, which may have a material adverse effect on the price of our common stock.

REGULATORY CHANGES MADE TO ACCOUNTING PRINCIPLES GENERALLY ACCEPTED IN THE UNITED STATES OF AMERICA OR CORPORATE GOVERNANCE MATTERS MAY IMPACT OUR BUSINESS

Revisions to accounting principles generally accepted in the United States of America will require us to review our accounting and financial reporting procedures in order to ensure continued compliance with required policies. From time to time, such changes may have a short-term impact on our reporting, and these changes may impact market perception of our financial condition. In addition, legislative changes, and the perception these changes create, can have a material, adverse effect on our business. For example:

• pending or new legislation may lead to an increase in our costs related to audits in particular and regulatory compliance generally; and

• changes in the legal climate may lead to additional liability concerns which may result in increased insurance costs.

OUR EXECUTIVE OFFICERS AND DIRECTORS CONTROL US AND MAY MAKE DECISIONS THAT SHAREHOLDERS DO NOT CONSIDER TO BE IN THEIR BEST INTERESTS

Our current directors and executive officers together beneficially own more than 50% of our outstanding common stock. Accordingly, these shareholders are able to control us through their ability to determine the outcome of the election of our directors, amend our Restated Articles of Incorporation and By-Laws and take other actions requiring the vote or consent of shareholders, including mergers, going private transactions and other extraordinary transactions, and the terms of any of these transactions. The ownership position of these shareholders may have the effect of delaying, deterring or preventing a change in control or a change in the composition of our board of directors.

ANTI-TAKEOVER PROVISIONS IN OUR ORGANIZATIONAL DOCUMENTS AND INDIANA LAW MAKE ANY CHANGE IN CONTROL OF US MORE DIFFICULT, MAY DISCOURAGE BIDS AT A PREMIUM OVER THE MARKET PRICE AND MAY ADVERSELY AFFECT THE MARKET PRICE OF OUR STOCK

Our Restated Articles of Incorporation and By-Laws contain provisions that may have the effect of delaying, deferring or preventing a change in control of us, may discourage bids at a premium over the market price of our common stock and may adversely affect the market price of our common stock, and the voting and other rights of the holders of our common stock. These provisions include:

• the division of our board of directors into three classes serving staggered three-year terms;

• removal of directors only for cause and only upon a 66 2/3% shareholder vote;

• prohibiting shareholders from calling a special meeting of shareholders;

• the ability to issue additional shares of our common stock or preferred stock without shareholders’ approval; and

• advance notice requirements for raising business or making nominations at shareholders’ meetings.

The Indiana corporation law contains business combination provisions that, in general, prohibit for five years any business combination with a beneficial owner of 10% or more of our common stock unless the holder’s acquisition of the stock was approved in advance by our board of directors. The Indiana corporation law also contains control share acquisition provisions that limit the ability of certain shareholders to vote their shares unless their control share acquisition was approved in advance.

WE CANNOT PREDICT EVERY EVENT AND CIRCUMSTANCE THAT MAY IMPACT OUR BUSINESS AND, THEREFORE, THE RISKS AND UNCERTAINTIES DISCUSSED ABOVE MAY NOT BE THE ONLY ONES YOU SHOULD CONSIDER

The risks and uncertainties discussed above are in addition to those that apply to most businesses generally. In addition, as we continue to grow our business, we may encounter other risks of which we are not aware at this time. These additional risks may cause serious damage to our business in the future, the impact of which we cannot estimate at this time.

Item 3. Quantitative and Qualitative Disclosures about Market Risk.

We develop products in the United States and sell licenses in the Americas, EMEA and APAC. 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 other local currencies. As a result, we will be subject to foreign currency fluctuations which may have an adverse affect on our 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. We have a line of credit with a variable interest rate based upon the bank’s prime rate on which we incur interest expense when the line is utilized.

Item 4. Controls and Procedures

We maintain a set of disclosure controls and procedures that are designed to ensure that information required to be disclosed by us in the reports filed by us under the Securities Exchange Act of 1934, as amended (Exchange Act) is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. We carried out an evaluation, under the supervision and with the participation of our management, including our President and Chief Executive Officer and our Chief Financial Officer and Treasurer, of the effectiveness of the design and operation of our disclosure controls and procedures as of June 30, 2004 pursuant to Rule 13a-15(b) of the Exchange Act. Based on that evaluation, our President and Chief Executive Officer and our Chief Financial Officer and Treasurer concluded that our disclosure controls and procedures are effective.

There have been no changes in our internal control over financial reporting that occurred during the quarter ended June 30, 2004 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

PART II. OTHER INFORMATION

Item 1. Legal Proceedings.

From time to time we have received claims from competitors and other technology providers claiming that our technology infringes their respective proprietary rights. One such claim has resulted in a legal proceeding being filed against us, which is described below. In addition, we are involved in certain legal proceedings in the ordinary course of conducting our business. We believe these claims and legal proceedings can be resolved without a material adverse effect on our business, financial condition or results from operations; however, we cannot provide assurance as to the outcome. Litigation in general, and intellectual property litigation in particular, can be expensive and disruptive to normal business operations. Moreover, the results of complex legal proceedings are difficult to predict.

In 2002, we received a letter from a consulting firm that 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 that we have infringed on the technology provider’s propriety rights and therefore feels that a licensing agreement between us and the technology provider is appropriate. We believe that we did not infringe on the technology provider’s proprietary rights; however, because of the cost of defending such a matter in court, we did offer a settlement. The technology provider has not accepted our offer of settlement. We do not believe a settlement is probable and the term over which a settlement would be recognized is uncertain. We may be required to defend our position in a court of law should a lawsuit be filed. Because of the facts presented above, we have not recorded an accrual for any settlement in this matter. We cannot provide assurance as to the outcome.

In 2002, we received a letter from one of our resellers requesting indemnification related to a request that the reseller had received for indemnification from a customer. The customer had received a letter from a third party indicating that the customer may be infringing patents held by the third party. To date, our patent counsel has not determined the validity or the applicability of these patents as they relate to our products or whether the reseller is entitled to indemnification. We believe that this matter can be resolved without a material adverse effect on our business, financial condition or results of operations; however, we cannot provide assurance as to the outcome.

On September 30, 2003, Recursion Software, Inc. filed suit in Dallas County Court in Dallas, Texas against us alleging breach of contract and money due under claims of quantum meruit, unjust enrichment and infringement. Recursion claims that we incorporated Recursion software into one of our products in breach of the underlying license. No dollar amount has been stated in the action. We believe that we have strong defenses to the claims and intend to vigorously defend against the action. We believe that this matter can be resolved without a material adverse effect on our business, financial condition or results of operations; however, we cannot provide assurance as to the outcome.

In 2002, we received a notification from the French government as a result of a tax audit that had been conducted encompassing the years 1998, 1999, 2000 and 2001. These assessments claim various taxes are owed related to Value Added Tax (VAT) and corporation taxes in addition to what has previously been paid and accrued. As of June 30, 2004, the assessment related to VAT was approximately $2.8 million and the assessment related to corporation taxes was approximately $366,000. Our tax counsel has assessed the possibility of us paying the assessment related to VAT as remote and the assessment related to corporation taxes as reasonably possible; we have not accrued for these amounts. We are appealing the assessments, but cannot assure you that these matters will be resolved without litigation or that we will not have to pay some or all of the assessments.

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

We held our annual meeting of shareholders on May 19, 2004. At that meeting, our shareholders elected Mark E. Hill and reelected William E. McWhirter as Directors of the Company to each serve a three-year term and until his successor is elected and has qualified. Also at the meeting, our shareholders approved an Amendment to our Outside Directors Stock Option Plan. The final results of the votes taken at the meeting were as follows:

	Votes For	Votes Withheld	Broker Non-Votes	Abstentions
	Votes For	Votes Withheld	Broker Non-Votes	Abstentions
Election of Directors:
Mark E. Hill	14,710,734	330,123	—	—
William E. McWhirter	14,706,954	333,903	—	—

Amendment to Outside Directors Stock Option Plan	11,000,645	572,115	3,444,533	23,564

In addition, the following directors continue in office until the annual meeting of shareholders in the year indicated:

Donald E. Brown, M.D.		2005
Robert A. Compton		2005
Samuel F. Hulbert, Ph.D.		2006

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

(a) Exhibits

31.1 Certification of the Chief Executive Officer pursuant to Rule 13a-14(a)/15d-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

31.2 Certification of the Chief Financial Officer pursuant to Rule 13a-14(a)/15d-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

32.1 Certification of Donald E. Brown, M.D., CEO, pursuant to 18 U. S. C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

32.2 Certification of Stephen R. Head, CFO, pursuant to 18 U. S. C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

(b) Reports on Form 8-K

1. On July 27, 2004, the Company furnished, not filed, a Form 8-K attaching a press release describing its results of operations for the quarter ended June 30, 2004.

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)
		Interactive Intelligence, Inc. (Registrant)

Date: August 6, 2004	By	/s/ Stephen R. Head

		Stephen R. Head Chief Financial Officer, Vice President of Finance and Administration, Secretary and Treasurer (Principal Financial Officer and Principal Accounting Officer)