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 March 31, 2005

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).

Yes o No ý

The number of shares of common stock outstanding on April 30, 2005 was 16,009,258.

PART I. FINANCIAL INFORMATION

Item 1. Condensed Consolidated Financial Statements and Footnotes.

Interactive Intelligence, Inc.

Condensed Consolidated Balance Sheets

As of March 31, 2005 and December 31, 2004

(in thousands, except share amounts)

	March 31, 2005			December 31, 2004
	(unaudited)			(Note 1)
Assets
Current assets:
Cash and cash equivalents	$	15,155		$	14,603
Accounts receivable, net of allowance for doubtful accounts of $470 in 2005 and $410 in 2004	10,119			10,251
Prepaid expenses	2,919			2,119
Other current assets	646			836
Total current assets	28,839			27,809
Property and equipment, net	4,039			4,071
Other assets, net	629			618
Total assets	$	33,507		$	32,498

Liabilities and Shareholders’ Equity
Current liabilities:
Line of credit	$	3,000		$	3,000
Accounts payable and accrued liabilities	5,467			5,894
Accrued compensation and related expenses	1,196			1,200
Deferred software revenues	4,693			4,484
Deferred services revenues	13,863			12,884
Total current liabilities	28,219			27,462
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; 15,983,071 issued and outstanding at March 31, 2005, 15,926,594 issued and outstanding at December 31, 2004	160			159
Additional paid-in capital	65,405			65,179
Accumulated deficit	(60,277		)	(60,302		)
Total shareholders’ equity	5,288			5,036
Total liabilities and shareholders’ equity	$	33,507		$	32,498

See Accompanying Notes to Condensed Consolidated Financial Statements

Interactive Intelligence, Inc.

Condensed Consolidated Statements of Operations (unaudited)

For the Three Months Ended March 31, 2005 and 2004

(in thousands, except per share amounts)

	Three Months Ended March 31,
	2005			2004
Revenues:
Software	$	7,795		$	6,993
Services	6,798			6,713
Total revenues	14,593			13,706
Cost of revenues:
Software	632			493
Services	2,841			2,855
Total cost of revenues	3,473			3,348
Gross profit	11,120			10,358
Operating expenses:
Sales and marketing	5,858			5,028
Research and development	3,195			3,278
General and administrative	2,063			1,871
Restructuring and other charges	—			16
Total operating expenses	11,116			10,193
Operating income	4			165
Interest income, net	51			7
Income before income taxes	55			172
Income taxes	30			52
Net income	$		25	$		120

Net income per share:
Basic	$	0.00		$	0.01
Diluted	0.00			0.01

Shares used to compute net income per share:
Basic	15,958			15,806
Diluted	16,554			16,700

See Accompanying Notes to Condensed Consolidated Financial Statements

Interactive Intelligence, Inc.

Condensed Consolidated Statement of Shareholders’ Equity (unaudited)

For the Three Months Ended March 31, 2005

(in thousands)

				Additional
	Common Stock			Paid-in		Accumulated
	Shares	Amount		Capital		Deficit			Total
Balances, December 31, 2004	15,927	$	159	$	65,179	$	(60,302	)	$	5,036

Issuances of common stock	19	—		57		—			57
Exercise of stock options	37	1		126		—			127
Stock-based compensation	—	—		43		—			43
Net income	—	—		—		25			25

Balances, March 31, 2005	15,983	$	160	$	65,405	$	(60,277	)	$	5,288

See Accompanying Notes to Condensed Consolidated Financial Statements

Interactive Intelligence, Inc.

Condensed Consolidated Statements of Cash Flows (unaudited)

For the Three Months Ended March 31, 2005 and 2004

(in thousands)

	Three Months Ended March 31,
	2005			2004
Operating activities:
Net income	$	25		$	120
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation	598			873
Amortization of deferred stock-based compensation	43			3
Changes in operating assets and liabilities:
Accounts receivable	132			1,610
Prepaid expenses	(800		)	(302		)
Other current assets	190			(221		)
Other assets	(11		)	(40		)
Accounts payable and accrued liabilities	(427		)	(12		)
Accrued compensation and related expenses	(4		)	77
Deferred software revenues	209			(495		)
Deferred services revenues	979			(151		)
Net cash provided by operating activities	934			1,462

Investing activities:
Purchases of property and equipment	(566		)	(364		)
Sales of available-for-sale investments	—			3,008
Net cash provided (used) by investing activities	(566		)	2,644

Financing activities:
Payments on line of credit, net	—			(1,600		)
Proceeds from issuance of common stock	57			72
Proceeds from stock options exercised	127			84
Net cash provided (used) by financing activities	184			(1,444		)

Net increase in cash and cash equivalents	552			2,662
Cash and cash equivalents, beginning of period	14,603			12,461
Cash and cash equivalents, end of period	$	15,155		$	15,123

Cash paid for interest	$	1		$	13
Cash paid for taxes	51			3

See Accompanying Notes to Condensed Consolidated Financial Statements

Interactive Intelligence, Inc.

Notes to Condensed Consolidated Financial Statements

March 31, 2005 and 2004 (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, voice mail 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 to 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.

Principal operations of the Company commenced during 1997. Since then, the Company has established wholly-owned subsidiaries in Australia, France, the Netherlands and the United Kingdom, and more recently introduced its Vonexus subsidiary for Global Enterprise IP Telephony and Microsoft small business customer markets. The Company also currently has branch offices in Canada, Germany, Hong Kong, Japan, Korea, Malaysia, Singapore and Sweden. The Company markets its software applications in the Americas; Europe, the Middle East and Africa (EMEA); and Asia/Pacific (APAC).

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, 2004 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, 2004, included in the Company’s Form 10-K for the year ended December 31, 2004, filed with the Securities and Exchange Commission on March 28, 2005. 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. Potential common shares are composed of shares of common stock issuable upon the exercise of stock options. The calculation of dilutive net income per share excludes shares underlying outstanding stock options with exercise prices that exceed the average market price of the Company’s common stock for the period, as the effect would be antidilutive.

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

	Three Months Ended March 31,
	2005		2004
Net income, as reported (A)	$	25	$	120

Weighted average outstanding shares of common stock (B)	15,958		15,806
Dilutive effect of options to purchase common stock	596		894
Common stock and common stock equivalent shares (C)	16,554		16,700

Net income per share:
Basic (A/B)	$	0.00	$	0.01
Diluted (A/C)	0.00		0.01

The Company’s calculation of diluted net income per share for the three months ended March 31, 2005 and 2004 excludes options to purchase 2.4 million and 1.2 million shares of common stock, respectively, as their 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 Statements No. 123 and 148. See Note 6 below for a discussion of upcoming changes to the accounting for stock-based compensation.

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 March 31,
	2005			2004
Net income, as reported	$	25		$	120
Add: Stock-based compensation expense included in reported net income, net of related tax effects	43			3
Deduct: Total stock-based compensation expense determined under fair-value-based method for all awards, net of related tax effect	(789		)	(769		)
Pro forma net loss	$	(721	)	$	(646	)

Net income (loss) per share:
Basic — as reported	$	0.00		$	0.01
Diluted — as reported	0.00			0.01
Basic — pro forma	(0.05		)	(0.04		)
Diluted — pro forma	(0.05		)	(0.04		)

4. Concentration of Credit Risk

Two resellers had greater than 10% concentration of accounts receivable and together represented 27% of accounts receivable as of March 31, 2005. No reseller represented greater than 10% of accounts receivable as of December 31, 2004.

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. The Company cannot assure you that these matters can be resolved amicably without litigation, or that the Company will be able to enter into licensing arrangements on terms and conditions that would not have a material adverse effect on its business, financial condition or results of operations.

On January 14, 2005, the Company entered into a non-exclusive license agreement with a telecommunication technology provider to use certain of its fax-related patents. Pursuant to this agreement, the Company has paid initial fees of $300,000 and recorded an accrual of $250,000 during the three months ended December 31, 2004 for additional fees the Company believes are probable. The Company may also pay up to an additional $475,000 in license fees if certain specified criteria are met.

In December 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 Company has not received any correspondence from the reseller since May 2003 and does not believe that this matter will have 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 and unjust enrichment. Recursion claims that the Company incorporated Recursion software into one of its

products in breach of the underlying license. On November 3, 2003, the Company had the case removed to Federal District Court in Dallas, Texas and on January 28, 2004, Recursion asserted a copyright infringement claim against the Company, which was expanded in scope on September 10, 2004. 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 November 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 March 31, 2005, the assessment related to VAT was approximately $3.0 million and the assessment related to corporation taxes was approximately $389,000. 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.

From time to time, the Company is also involved in certain legal proceedings in the ordinary course of conducting its 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 its financial position or results of operations. 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.

6. Recent Accounting Pronouncements

In December 2004, the FASB issued FASB Statement No. 123R, Share-Based Payment, which establishes standards for transactions in which an entity exchanges its equity instruments for goods or services. This standard requires a public entity to measure the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award. This eliminates the exception to account for such awards using the intrinsic value-based method previously allowable under APB Opinion No. 25 (see Note 3 above). In March 2005, the Securities and Exchange Commission (SEC) released Staff Accounting Bulletin (SAB) 107, Share-Based Payment, which expresses views of the SEC staff about the application of FASB Statement No. 123R. FASB Statement No. 123R was to be effective for interim or annual reporting periods beginning on or after June 15, 2005, but in April 2005 the SEC issued a rule that FASB Statement No. 123R will be effective for annual reporting periods beginning on or after June 15, 2005. The Company expects that the adoption will have a significant adverse impact on its consolidated net income and net income per share.

In December 2004, the FASB issued FASB Statement No. 153, Exchanges of Nonmonetary Assets - an amendment of APB Opinion No. 29 (Accounting for Nonmonetary Transactions). FASB Statement No. 153 requires that exchanges of nonmonetary assets be measured based on the fair value of the assets exchanged. Further, it expands the exception for nonmonetary exchanges of similar productive assets to nonmonetary assets that do not have commercial substance. The provisions of FASB Statement No. 153 are effective for nonmonetary asset exchanges occurring in fiscal periods beginning after June 15, 2005. The adoption of the provisions of FASB Statement No. 153 is not expected to have a material impact on the Company’s consolidated financial position or results of operations.

In December 2004, the FASB issued FASB Staff Position No. 109-1 (FAS 109-1), Application of FASB Statement No. 109, Accounting for Income Taxes, to the Tax Deduction on Qualified Production Activities Provided by the American Jobs Creation Act of 2004 (AJCA). The AJCA introduces a special phased in tax deduction, starting at 3%, on qualified production activities. FAS 109-1 clarifies that this tax deduction should be accounted for as a special tax deduction in accordance with FASB Statement No. 109.

The Company does not expect the adoption of these new tax provisions to have a material impact on its consolidated financial position, results of operations or cash flows.

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 “Certain 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, 2004.

Overview

We are a leading provider of software applications for contact centers and plan 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: North America; Europe, Middle East and Africa (EMEA); and Australia and other Asia/Pacific countries (APAC).

Financial Highlights

For the years ending December 31, 2004 and 2003 we saw a growth rate in revenues of 7% and 8%, respectively. Revenue growth within any given quarter varies. Factors such as our potential customers’ budget constraints, personnel resources to implement the software, and willingness to implement a critical telecommunications system, can affect the timing of when our revenues occur.

The information below shows our total revenues (in millions) for the most recent five quarters and the previous two years and percentage change over the previous period.

Period	Revenues		% Growth
Three months ended:
March 31, 2005	$	14.6	2	%
December 31, 2004	14.4		7
September 30, 2004	13.4		(2	)
June 30, 2004	13.6		—
March 31, 2004	13.7		6

Year ended December 31:
2004	$	55.1	7	%
2003	51.5		8

Our experience is that once companies have implemented our software and the personnel at these companies experience the capabilities and efficiencies of our software, these companies increase their technology spending for our software. However, we cannot assure you that this will continue to be the case. 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 March 31, 2005 increased $887,000 over revenues for the three months ended March 31, 2004. Beginning in the first quarter of 2004, we began offering perpetual licenses to our new customers and therefore the recognition of revenues on new contracts signed in 2004 was accelerated compared to how revenues were previously recognized under typical annually renewable licenses. Because the three months ended March 31, 2004 was the first quarter the perpetual contracts were offered, there was not yet a large percentage of perpetual contracts during that quarter. In the three months ended March 31, 2005, 63% of the software revenues recognized were related to perpetual license agreements compared to 39% of the software revenues in the three months ended March 31, 2004.

We formed a new subsidiary, Vonexus, on July 1, 2004. Vonexus is focused on selling a complete IP-based phone system, including hardware, to Microsoft-based small and medium-sized businesses. As a result of the formation of Vonexus and this new market focus, we have experienced higher expenses in sales and marketing since the third quarter of 2004. In the first quarter of 2005 we recognized our first revenues related to Vonexus, which were minimal. We expect the higher sales and marketing costs to continue. However, we expect to record additional revenues in 2005 from Vonexus, which will partially offset these additional expenses. 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.

Operating expenses for the three months ended March 31, 2005 increased $923,000 compared to the three months ended March 31, 2004. This increase was the result of an increase in sales and marketing expenses, principally due to costs for our subsidiary, Vonexus, and an increase in general and administrative expenses due to increasing headcount, partially offset by lower legal costs, depreciation and insurance expenses. Research and development expenses decreased slightly.

We had approximately $15.2 million of cash and cash equivalents as of March 31, 2005. We had borrowings under a line of credit of $3.0 million as of March 31, 2005, which has since been repaid in full. We believe that if our revenues increase, our accounts receivable are collected timely and our expenses remain controlled, we will maintain or increase our liquidity position. If revenues decrease, or if we are unable to collect our account receivable balances from our customers on a timely basis, our liquidity position may weaken, which would result in the need to raise capital, either through the capital markets or debt financings.

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 months ended March 31, 2005 and 2004 are not necessarily indicative of the results that may be expected for the full year or for any future period.

	Three Months Ended March 31,
	2005		2004
Revenues:
Software	53	%	51	%
Services	47		49
Total revenues	100		100
Cost of revenues:
Software	4		3
Services	20		21
Total cost of revenues	24		24
Gross profit	76		76
Operating expenses:
Sales and marketing	40		37
Research and development	22		24
General and administrative	14		14
Restructuring and other charges	—		—
Total operating expenses	76		75
Operating income	—		1
Interest income, net	—		—
Income before income taxes	—		1
Income taxes	—		—
Net income	—	%	1	%

Comparison of Three Months Ended March 31, 2005 and 2004

Revenues

Software Revenues

	Three Months Ended March 31,
	2005			2004
	($ in thousands)
Software revenues	$	7,795		$	6,993
Change from prior year	11		%	(19		)%
Percentage of total revenues	53		%	51		%

The increase in software revenues for the three months ended March 31, 2005 compared to the three months ended March 31, 2004, was related primarily to an increase in the percentage of perpetual license agreements we recognized in 2005. Beginning in the first quarter of 2004, we began offering perpetual licenses to our new customers and therefore the recognition of revenues on new contracts signed in 2004 was accelerated compared to how revenues were recognized under annually renewable licenses in 2004. Because the three months ended March 31, 2004 was the first quarter the perpetual contracts were offered, there was not yet a large percentage of perpetual contracts during that quarter. In the three months ended March 31, 2005, 63% of the software revenues recognized were related to perpetual license agreements compared to 39% of the software revenues in the three months ended March 31, 2004.

Services Revenues

	Three Months Ended March 31,
	2005			2004
	($ in thousands)
Services revenues	$	6,798		$	6,713
Change from prior year	1		%	16		%
Percentage of total revenues	47		%	49		%

Services revenues remained relatively constant for the three months ended March 31, 2005 compared to the three months ended March 31, 2004. Our services revenues should grow as we sign and install new customers and as existing customers continue to renew licenses and pay for maintenance on our software applications. For the three months ended March 31, 2005, maintenance revenues grew 15% over the three months ended March 31, 2004, however, other services revenue (such as education and global services revenues) declined during the three months ended March 31, 2005 compared to the three months ended March 31, 2004. The percent of services revenues to total revenues decreased slightly due to the increase in software revenues.

Cost of Revenues

	Three Months Ended March 31,
	2005			2004
	($ in thousands)
Cost of revenues:
Software	$	632		$	493
Services	2,841			2,855
Total cost of revenues	$	3,473		$	3,348
Total change from prior year	4		%	(4		)%
Software costs as a % of software revenues	8		%	7		%
Services costs as a % of services revenues	42		%	43		%

Costs of software consist primarily of product and software royalties paid to third parties for the use of their technologies in our products, hardware costs related to Vonexus 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, the third party technology, if any, which is licensed and the number of Vonexus systems sold. The increase in the software costs for the three months ended March 31, 2005 compared to the three months ended March 31, 2004 was due to increased royalties for third party software and Vonexus hardware.

Costs of services consist primarily of compensation expenses for technical support, education and professional services personnel, hardware costs related to Interactive Intelligence and other costs associated with supporting our resellers and customers. These costs remained relatively constant for the three months ended March 31, 2005 compared to the three months ended March 31, 2004.

Gross Profit

	Three Months Ended March 31,
	2005			2004
	($ in thousands)
Gross profit	$	11,120		$	10,358
Change from prior year	7		%	(5		)%
Percentage of total revenues	76		%	76		%

Gross profit increased for the three months ended March 31, 2005 compared to March 31, 2004. This increase was mainly the result of an increase in software revenues as discussed above. Gross profit as a percentage of total revenues was constant.

Operating Expenses

Sales and Marketing

	Three Months Ended March 31,
	2005			2004
	($ in thousands)
Sales and marketing expenses	$	5,858		$	5,028
Change from prior year	17		%	(3		)%
Percentage of total revenues	40		%	37		%
Percentage of software revenues	75		%	72		%

Sales and marketing expenses are comprised primarily of compensation expense, travel, marketing, entertainment and other related expenses. These expenses increased for the three months ended March 31, 2005 compared to March 31, 2004. As anticipated and discussed in our Form 10-K for the year ended December 31, 2004, the majority of this increase was due to payroll expenses and other costs associated with Vonexus, our wholly-owned subsidiary. As described previously under Financial Highlights, we expect these Vonexus costs to continue, although we expect to record increased revenues from Vonexus in the second quarter to offset some of the increased expenses.

Research and Development

	Three Months Ended March 31,
	2005			2004
	($ in thousands)
Research and development expenses	$	3,195		$	3,278
Change from prior year	(3		)%	(6		)%
Percentage of total revenues	22		%	24		%

Research and development expenses are comprised primarily of compensation expenses. Research and development expenses decreased slightly for the three months ended March 31, 2005 compared to March 31, 2004 due to a decrease in staffing and lower depreciation expense as certain of our assets become fully depreciated, partially offset by increased software purchases and increased costs of localization of our software.

General and Administrative

	Three Months Ended March 31,
	2005			2004
	($ in thousands)
General and administrative expenses	$	2,063		$	1,871
Change from prior year	10		%	29		%
Percentage of total revenues	14		%	14		%

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 months ended March 31, 2005 compared to March 31, 2004. This increase was the result of higher payroll expenses due to increased staffing and an increase in other office expenses as well as a decrease in gains from foreign exchange. This increase was partially offset by decreases in depreciation, premiums for corporate insurance and legal services.

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. Interest earnings improved during the three months ended March 31, 2005 compared to the three months ended March 31, 2004 as shown below.

	Three Months Ended March 31,
	2005			2004
	($ in thousands)
Cash, cash equivalents and short-term investments (average)	$	14,879			$	15,296
Interest income	52				20
Return on investment	1.4		%		.5		%

The increase in net interest income for the three months ended March 31, 2005 compared to March 31, 2004 was related mainly to a change in the funds that we invested in. The new funds have a higher interest rate and lower fees.

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 we fully utilized as of March 31, 2005, all of which was repaid in full subsequent to March 31, 2005. 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.

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 improved as of March 31, 2005 compared with our position as of December 31, 2004. We did not have any short-term investments at March 31, 2005 or December 31, 2004. 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.

	March 31, 2005			December 31, 2004
	($ in thousands)
Cash and cash equivalents	$	15,155		$	14,603
Line of credit	(3,000		)	(3,000		)
Liquidity, net	$	12,155		$	11,603

Our operating activities resulted in net cash provided of $934,000 and $1.5 million for the three months ended March 31, 2005 and 2004, respectively. For the three months ended March 31, 2005, the decrease in cash provided from operating activities was a result of an increase in deferred revenues, offset by an increase in prepaid expenses and a decrease in accounts payable.

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 $566,000 and $364,000 in the three months ended March 31, 2005 and 2004, respectively. These purchases related mainly to in-house technology.

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 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 but at times may be more than 12 months because maintenance begins when the licenses are downloaded which is typically within six months of the contract date.

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 the actual renewal fee. 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 annual maintenance fees as services revenues ratably over the post-contract maintenance period, which is typically 12 months.

We also generate revenues from other services that we provide to our resellers and customers. These additional 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 our products for a customer, are 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 an average bad debt expense to revenue ratio and 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 and ultimately terminating the customer’s or 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

Through March 31, 2005, all research and development expenditures have been 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.

Certain 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 weakens, demand for our products could decrease, resulting in lower revenues.

WE HAVE HISTORICALLY INCURRED LOSSES AND WE MAY NOT SUSTAIN PROFITABILITY

Since the first quarter of 2004, we have reported net income. We have historically incurred losses and may do so again in the future. We incurred net losses of $5.9 million and $7.7 million in 2003 and 2002, respectively. At March 31, 2005, we had accumulated net losses since inception of $60.3 million. We intend to continue to make significant investments in our research and development, marketing, services, sales operations and our new subsidiary, Vonexus. In addition, as discussed in Note 6 of Notes to Consolidated Financial Statements, FASB Statement No. 123R will have an adverse effect on our operating results when we implement it. As a result, we may 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) 104, 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.

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. In addition, the formation of our wholly-owned subsidiary, Vonexus, which offers through resellers a whole product solution, has added complexity to those third party relationships. 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 competitive pressures to continue to be a risk to our ongoing success in the market. 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 provide assurance 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 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 more effectively than we can, or to devote greater resources to the development, promotion and sale of products than we can. In addition, for a number of our larger competitors, the product segment in which they currently compete with us is a small portion of their overall offering. These competitors might be willing and able to dramatically cut prices in our segment in order to protect or grow other segments that are more important to their overall business. 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 significantly increased 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 PARTNERS AND CONTINUE TO RECRUIT AND DEVELOP ADDITIONAL SUCCESSFUL RESELLERS AND 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 partners and in recruiting and training additional resellers and 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 distribution networks and may be unable to attract additional resellers with both voice and data expertise or appropriate 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 partners, and the loss of specific larger resellers or partners or a significant

number of resellers or 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 competing 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 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 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 license 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 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 27%, 22% and 13% of our total revenues for the three months ended March 31, 2005 and the years ended December 31, 2004 and 2003, respectively. We have marketing efforts in the Americas, EMEA and APAC. 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 that 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, 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.

Our software runs on a Windows 2000 or Windows 2003 server and for telephone call processing uses voice processing boards or third party VoIP media processing software such as Intel HMP software. Our server software also operates in a complex network environment with database servers, email servers and other third party systems. Because of this complexity, it may be more prone to performance interruptions for our customers than traditional hardware-based products. Performance interruptions at our 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.

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 relatively 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 GENERALLY ACCEPTED ACCOUNTING PRINCIPLES OR CORPORATE GOVERNANCE MATTERS MAY IMPACT OUR BUSINESS

Revisions to generally accepted accounting principles 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, such as the Sarbanes-Oxley 404 regulations, 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 license our products 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 March 31, 2005 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 were effective.

There have been no changes in our internal control over financial reporting that occurred during the quarter ended March 31, 2005 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 proprietary rights. One such claim has resulted in a legal proceeding being filed against us, which is described below. We cannot assure you that these matters 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 December 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. We have not received any correspondence from the reseller since May 2003 and do not believe that this matter will have 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. On November 6, 2003, we had the case removed to Federal District Court in Dallas, Texas and on January 28, 2004, Recursion asserted a copyright infringement claim against us, which was expanded in scope on September 10, 2004. 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 November 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 March 31, 2005, the assessment related to VAT was approximately $3.0 million and the assessment related to corporation taxes was approximately $389,000. 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.

From time to time, we are also involved in certain intellectual property claims and 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 claims and legal proceedings will not have a material adverse effect on our business, financial condition or results from operations. 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

Item 6. Exhibits.

(a) Exhibits

3.1 Restated Articles of Incorporation of the Company (incorporated herein by reference from the same exhibit number to the Company’s Registration Statement on Form S-1 (Registration No. 333-79509))

3.2 By-Laws of the Company, as amended to date (incorporated herein by reference from the same exhibit number to the Company’s Registration Statement on Form S-1 (Registration No. 333-79509))

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

		Interactive Intelligence, Inc.
		(Registrant)


Date: May 10, 2005	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)

PART I. FINANCIAL INFORMATION		3

Item 1.	Condensed Consolidated Balance Sheets as of March 31, 2005 and December 31, 2004	3

	Condensed Consolidated Statements of Operations for the three months ended March 31, 2005 and 2004	4

	Condensed Consolidated Statement of Shareholders’ Equity for the three months ended March 31, 2005	5

	Condensed Consolidated Statements of Cash Flows for the three months ended March 31, 2005 and 2004	6

	Notes to Condensed Consolidated Financial Statements	7

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	11

Item 3.	Quantitative and Qualitative Disclosures About Market Risk	26

Item 4.	Controls and Procedures	27

PART II. OTHER INFORMATION		27

Item 1.	Legal Proceedings	27

Item 6.	Exhibits	28

SIGNATURES		29