** **

**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

 

**Washington, D.C. 20549**

 

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**FORM 10-Q**

 

| **(Mark  One)**                                   |
|---------------------------------------------------|
|                                              |
| **ý**                                        |   | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE  SECURITIES EXCHANGE ACT OF 1934** |
|                                              |
| **For the quarterly period ended June  30, 2002** |
|                                              |
| **Or**                                            |
|                                              |   |   |
| **o**                                             |   | **TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE  SECURITIES EXCHANGE ACT OF 1934** |
|                                                   |  |  |  |  |

** **

**For the transition periodfrom              to              **

 

**CommissionFile Number 000-27385**

 

**INTERACTIVE INTELLIGENCE, INC.**

(Exactname of registrant as specified in its charter)

 

| **Indiana**                                                    |   | **35-1933097**                    |
|----------------------------------------------------------------|--------|-----------------------------------|
| (State or other jurisdiction of incorporation or organization) |   | (IRS Employer Identification No.) |
|                                                           |   |                              |
| **8909 Purdue Road  Suite 300  Indianapolis, Indiana 46268**   |
| (Address of principal executive offices)                       |
|                                                           |   |                              |
| **(317) 872-3000**                                             |
| (Registrant's telephone number)                                |

 

Indicate by checkmarkwhether the registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements for thepast 90 days.

 

Yes  ý   No  o

 

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

 

 

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TABLE OF CONTENTS

 
| PART I. FINANCIAL  INFORMATION |
|--------------------------------|
|                           |   |
| Item 1.                        | Condensed  Consolidated Balance Sheets as of June 30, 2002 and December 31, 2001 |
|                           |   |
|                           | Condensed  Consolidated Statements of Operations for the three and six months ended June  30, 2002 and 2001 |
|                           |   |
|                           | Condensed  Consolidated Statements of Cash Flows for the six months ended June 30, 2002  and 2001 |
|                           |   |
|                           | Notes  to Condensed Consolidated Financial Statements |
|                           |   |
| Item  2.                       | Management's  Discussion and Analysis of Financial Condition and Results of Operations |
|                           |   |
| Item  3.                       | Quantitative  and Qualitative Disclosures About Market Risk |
|                           |   |
| PART II. OTHER INFORMATION     |
|                           |   |
| Item 1.                        | Legal Proceedings |
|                           |   |
| Item  4.                       | Submission  of Matters to a Vote of Security Holders |
|                           |   |
| Item 6.                        | Exhibits and  Reports on Form 8-K |
|                           |   |
|                           | Signature |
|                                |  |  |

 

2

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** **

** **

**PARTI.  FINANCIAL INFORMATION**

 

**Item 1****.  Condensed Consolidated Financial Statementsand Footnotes.**

** **

**Interactive Intelligence,Inc.**

**Condensed Consolidated Balance Sheets**

**(in thousands, except share amounts)**

 
|                                                                                                                                                                |   | **June 30,  2002**  | ** ** | **December  31,  2001** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|---------------------|------------|-------------------------|------------|
|                                                                                                                                                                |   | **(Unaudited****)** | ** ** |                    | ** ** |
| **Assets**                                                                                                                                                          |   |                |       |                    | ** ** |
| Current assets:                                                                                                                                                     |   |                |       |                    |       |
| Cash and cash equivalents                                                                                                                                           |   | $                   | 5,291      |                    | $          | 14,503 |   |
| Short-term investments                                                                                                                                              |   | 12,378              |       | 7,581                   |       |
| Accounts receivable, net of allowance for doubtful accounts accounts  of $713 in 2002 and $677 in 2001                                                              |   | 8,242               |       | 8,424                   |       |
| Prepaid expenses                                                                                                                                                    |   | 882                 |       | 1,116                   |       |
| Other current assets                                                                                                                                                |   | 119                 |       | 223                     |       |
| Total current assets                                                                                                                                                |   | 26,912              |       | 31,847                  |       |
|                                                                                                                                                                |   |                |       |                    |       |
| Property and equipment, net                                                                                                                                         |   | 8,738               |       | 9,598                   |       |
|                                                                                                                                                                |   |                |       |                    |       |
| Other assets, net                                                                                                                                                   |   | 1,150               |       | 1,064                   |       |
| Total assets                                                                                                                                                        |   | $                   | 36,800     |                    | $          | 42,509 |   |
|                                                                                                                                                                |   |                |       |                    |       |
| **Liabilities and shareholders' equity**                                                                                                                            |   |                |       |                    |       |
| Current liabilities:                                                                                                                                                |   |                |       |                    |       |
| Accounts payable and accrued liabilities                                                                                                                            |   | $                   | 3,669      |                    | $          | 3,924 |   |
| Accrued compensation and related expenses                                                                                                                           |   | 842                 |       | 1,096                   |       |
| Deferred revenue                                                                                                                                                    |   | 9,830               |       | 9,214                   |       |
| Total current liabilities                                                                                                                                           |   | 14,341              |       | 14,234                  |       |
|                                                                                                                                                                |   |                |       |                    |       |
| Shareholders' equity:                                                                                                                                               |   |                |       |                    |       |
| Preferred stock,  no par  value;  10,000,000 authorized; no  shares issued and outstanding                                                                |   | —              |       | —                  |       |
| Common stock, $0.01 par value; 100,000,000 authorized; 15,422,418  issued and outstanding at June 30, 2002, 15,282,673 issued and outstanding at  December 31, 2001 |   | 154                 |       | 153                     |       |
| Additional paid-in capital                                                                                                                                          |   | 63,907              |       | 63,485                  |       |
| Accumulated other comprehensive income                                                                                                                              |   | 81                  |       | (13                     | )          |
| Accumulated deficit                                                                                                                                                 |   | (41,683             | )          | (35,350                 | )          |
| Total shareholders' equity                                                                                                                                          |   | 22,459              |       | 28,275                  |       |
| Total liabilities and shareholders' equity                                                                                                                          |   | $                   | 36,800     |                    | $          | 42,509 |   |

 

See accompanying notes.

 

3

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**Interactive Intelligence,Inc.**

** **

**Condensed Consolidated Statements of Operations****(unaudited)**

**(in thousands, except per share amounts)**

** **
|                                       |   | **Three  months ended  June 30,** | ** ** | **Six months  ended  June 30,** | ** ** |
|--------------------------------------------|--------|-----------------------------------|------------|---------------------------------|------------|
|                                       |   | **2002**                          | ** ** | **2001**                        | ** ** | **2002** | ** ** | **2001** | ** ** |
| Revenues:                                  |   |                              |       |                            |       |   |   |   |   |
| Software                                   |   | $                                 | 6,947      |                            | $          | 8,379 |   | $ | 12,993 |   | $ | 17,291 |   |
| Services                                   |   | 4,416                             |       | 4,362                           |       | $ | 8,777 |   | 8,130 |   |
| Total revenues                             |   | 11,363                            |       | 12,741                          |       | 21,770 |   | 25,421 |   |
|                                       |   |                              |       |                            |       |   |   |   |   |
| Costs and expenses:                        |   |                              |       |                            |       |   |   |   |   |
| Costs of software                          |   | 250                               |       | 154                             |       | 578 |   | 303 |   |
| Costs of services                          |   | 2,865                             |       | 3,720                           |       | 5,888 |   | 7,280 |   |
| Sales and marketing                        |   | 5,132                             |       | 5,867                           |       | 10,563 |   | 11,301 |   |
| Research and development                   |   | 3,712                             |       | 3,936                           |       | 7,618 |   | 7,818 |   |
| General and administrative                 |   | 1,381                             |       | 2,033                           |       | 2,878 |   | 3,636 |   |
| Special charge                             |   | 682                               |       | —                          |       | 682 |   | — |   |
| Total costs and expenses                   |   | 14,022                            |       | 15,710                          |       | 28,207 |   | 30,338 |   |
| Operating loss                             |   | (2,659                            | )          | (2,969                          | )          | (6,437 | ) | (4,917 | ) |
|                                       |   |                              |       |                            |       |   |   |   |   |
| Interest income, net                       |   | 104                               |       | 349                             |       | 233 |   | 667 |   |
| Loss before income taxes                   |   | (2,555                            | )          | (2,620                          | )          | (6,204 | ) | (4,250 | ) |
|                                       |   |                              |       |                            |       |   |   |   |   |
| Income taxes                               |   | 60                                |       | 81                              |       | 129 |   | 141 |   |
|                                       |   |                              |       |                            |       |   |   |   |   |
| Net loss                                   |   | $                                 | (2,615     | )                               | $          | (2,701 | ) | $ | (6,333 | ) | $ | (4,391 | ) |
|                                       |   |                              | ** ** |                            | ** ** |   | ** ** |   | ** ** |
| Net loss per share:                        |   |                              | ** ** |                            | ** ** |   | ** ** |   | ** ** |
| Basic and diluted                          |   | $                                 | (0.17      | )                               | $          | (0.18 | ) | $ | (0.41 | ) | $ | (0.29 | ) |
|                                       |   |                              |       |                            |       |   |   |   |   |
| Shares used to compute net loss per share: |   |                              |       |                            |       |   |   |   |   |
| Basic and diluted                          |   | 15,398                            |       | 15,039                          |       | 15,368 |   | 14,921 |   |

 

See accompanying notes.

 

4

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**Interactive Intelligence, Inc.**

 

**Condensed Consolidated Statements of Cash Flows (unaudited)**

**(in thousands)**

 
|                                                                         |   | **Six months  ended  June 30,** | ** ** |
|------------------------------------------------------------------------------|--------|---------------------------------|------------|
|                                                                         |   | **2002**                        | ** ** | **2001** | ** ** |
| **Operating activities**                                                     |   |                            |       |   |   |
| Net loss                                                                     |   | $                               | (6,333     | ) | $ | (4,391 | ) |
| Adjustments to reconcile net loss to net cash used by operating  activities: |   |                            |       |   |   |
| Depreciation                                                                 |   | 2,570                           |       | 1,962 |   |
| Amortization of deferred stock-based compensation                            |   | 66                              |       | 38 |   |
| Changes in operating assets and liabilities:                                 |   |                            |       |   |   |
| Accounts receivable                                                          |   | 182                             |       | (1,703 | ) |
| Prepaid expenses                                                             |   | 234                             |       | (425 | ) |
| Other current assets                                                         |   | 104                             |       | (284 | ) |
| Accounts payable and accrued liabilities                                     |   | (255                            | )          | (551 | ) |
| Accrued compensation and related expenses                                    |   | (254                            | )          | 761 |   |
| Deferred revenue                                                             |   | 616                             |       | 4,497 |   |
| Net cash used by operating activities                                        |   | (3,070                          | )          | (96 | ) |
|                                                                         |   |                            |       |   |   |
| **Investing activities**                                                     |   |                            |       |   |   |
| Purchases of property and equipment, net                                     |   | (1,710                          | )          | (3,352 | ) |
| Purchases of available-for-sale investments                                  |   | (9,121                          | )          | (10,225 | ) |
| Sales of available-for-sale investments                                      |   | 4,418                           |       | 4,677 |   |
| Change in other assets                                                       |   | (86                             | )          | (274 | ) |
| Net cash used by investing activities                                        |   | (6,499                          | )          | (9,174 | ) |
|                                                                         |   |                            |       |   |   |
| **Financing activities**                                                     |   |                            |       |   |   |
| Principal payments on capital lease obligations                              |   | —                          |       | (255 | ) |
| Proceeds from issuances of common stock                                      |   | 248                             |       | 15,147 |   |
| Proceeds from stock options exercised                                        |   | 109                             |       | 268 |   |
| Net cash provided by financing activities                                    |   | 357                             |       | 15,160 |   |
|                                                                         |   |                            |       |   |   |
| Net increase (decrease) in cash and cash equivalents                         |   | (9,212                          | )          | 5,890 |   |
|                                                                         |   |                            |       |   |   |
| Cash and cash equivalents, beginning of period                               |   | 14,503                          |       | 1,999 |   |
| Cash and cash equivalents, end of period                                     |   | $                               | 5,291      |   | $ | 7,889 |   |

 

See accompanying notes.

 

5

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InteractiveIntelligence, Inc

Notes to CondensedConsolidated Financial Statements

(Unaudited)

 

**1.****                 Descriptionof Business and Basis of Presentation**

 

InteractiveIntelligence, Inc. (“I3” or the “Company”) is a leading provider ofsoftware-based interaction management solutions designed to automatecommunications for contact centers, enterprises, and service providers. Basedon an open, unified platform, the Interactive Intelligence product line wasdesigned as a flexible and affordable alternative to traditional telecomsolutions. The Company’s products provide a complete communications solutionincluding PBX (private branch exchange), ACD (automated call distributor), IVR(interactive voice response), unified communications, and Internet and wirelessfunctionality.  The Company currentlyderives substantially all of its revenues from licenses of its InteractionCenter platform products and related services.

 

Principal operations of the Company commenced during1997.  Since then, the Company hasestablished wholly-owned subsidiaries in France, Australia and the UnitedKingdom. The Company also currently has branch offices in Japan, Korea, Malaysia, and the Netherlands.  The Company’s products are marketed in NorthAmerica, Central America, South America, Europe, the Asia/Pacific region,Australia, and South Africa.

 

The accompanying unaudited financial statements havebeen prepared in conformity with generally accepted accounting principles forinterim financial information and with the instructions for Form 10-Q andArticle 10 of Regulation S-X. Accordingly, certain information and footnote disclosures normallyincluded in financial statements prepared in accordance with generally acceptedaccounting principles have been condensed, or omitted, pursuant to the rulesand regulations of the Securities and Exchange Commission.  In our opinion, the statements include alladjustments necessary  (which are of anormal and recurring nature) for the fair presentation of the results of theinterim periods presented.  

 

The balance sheet at December 31, 2001 has beenderived from the audited financial statements at that date but does not includeall of the information and footnotes required by generally accepted accountingprinciples for complete financial statements.

 

These financial statements should be read inconjunction with our audited consolidated financial statements for the yearended December 31, 2001, included in the Company’s Form 10-K for the year endedDecember 31, 2001, filed with the Securities and Exchange Commission on April1, 2002.  Our results of operations forany interim period are not necessarily indicative of the results of operationsfor any other interim period or for a full fiscal year. 

 

**2.****                 NetLoss Per Common Share**

 

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

 

6

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

 
|                                                         |   | **Three  Months Ended  June 30,** |   | **Six Months  Ended  June 30,** |   |
|--------------------------------------------------------------|--------|-----------------------------------|--------|---------------------------------|--------|
|                                                         |   | **2002**                          |   | **2001**                        |   | **2002** |   | **2001** |   |
|                                                         |   |                              |   |                            |   |   |   |   |   |
| Net Loss:                                                    |   | $                                 | (2,615 | )                               | $      | (2,701 | ) | $ | (6,333 | ) | $ | (4,391 | ) |
|                                                         |   |                              |   |                            |   |   |   |   |   |
| Basic and  diluted:                                          |   |                              |   |                            |   |   |   |   |   |
| Weighted-average  shares used to compute net loss per share: |   | 15,398                            |   | 15,039                          |   | 15,368 |   | 14,921 |   |
|                                                         |   |                              |   |                            |   |   |   |   |   |
| Basic and  diluted net loss per common share:                |   | $                                 | (0.17  | )                               | $      | (0.18 | ) | $ | (0.41 | ) | $ | (0.29 | ) |

 

The Company’s calculation of diluted net loss pershare excludes potential common shares as the effect would beantidilutive.  Potential common sharesare composed of shares of common stock of the Company issuable on the exerciseof stock options.  Options to purchase3,205,447 shares of common stock with exercise prices of $0.13 to $50.50 pershare were outstanding as of June 30, 2002 and options to purchase 2,558,774shares of common stock with exercise prices of $0.13 to $50.50 per share wereoutstanding as of June 30, 2001.

 

**3.****                 BankLine of Credit**

 

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

 

**4.****                 Reclassifications**

** **

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

** **

**5.****                 Contingencies**

 

In June 1999 and September 1999, the Company receivedletters from a competitor in the call center market claiming that the Company'sproducts utilize technologies pioneered and patented by that competitor.  The Company's patent counsel has reviewedall of the patents listed in the letters. Based on the advice of the Company's patent counsel, the Companybelieves that its products do not infringe any of the patents listed in eitherletter.  The Company has discussed itsconclusion with the competitor and has also discussed possible licensing ofcertain technologies from the competitor. The Company cannot assure you that this matter can be resolved amicablywithout litigation, or that it will ultimately be able to enter into alicensing arrangement on terms and conditions that would not have a materialadverse effect on the Company's business, financial condition or results ofoperations.

 

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

 

7

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

 

In July 2000, the Company received a letter fromAvaya, Inc., a competitor in the call center market, claiming that theCompany's products utilize technologies pioneered and patented by them.  As a result of subsequent discussions, theCompany accrued an appropriate amount for the licensing of certain technologiesrelated to 2001 and prior years in the financial statements for the year endedDecember 31, 2001.  An agreement wasfinalized and executed in February 2002 and the Company believes the terms andconditions of the licensing arrangement will not have a material adverse effecton the Company's business, financial condition or results of operations.

 

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

 

Other third parties could claim that our technologyinfringes their proprietary rights. Infringement claims, even if without merit, can be time consuming andexpensive to defend. A third party asserting infringement claims against us orour customers with respect to our current or future products may require us toenter into costly royalty arrangements or litigation, or otherwise materiallyadversely affect us.

 

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

 

**6.****                                     Special Charge**

 

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

 

**Item2.  Management’s Discussion and Analysisof Financial Condition and Results of Operations**

 

*Forward-LookingInformation*

 

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

 

*Overview*

 

We commenced operationsin October 1994. Through the end of 1996, we focused primarily on researchand development activities. Our first product was released in March 1997.In 1997 and 1998, we expanded our operations to capitalize on the increasedmarket demand for communications and interaction management software. Wedecided, at the expense of profitability, to continue investing significantlyin research and development, and to accelerate our investments in marketing,services and sales operations. We had no revenue in 1996, and our totalrevenues were $1.6 million in 1997, $9.0 million in 1998,$19.1 million in 1999, $38.6 million in 2000, and $50.1 million in2001.   However, we cannot assure youthat our revenues will grow at such rates or at all in the future. We believeour investments in research and development and in marketing, services andsales operations will continue to be critical to any revenue growth weexperience. However, these investments have also significantly increased ouroperating costs and expenses, contributing to the net losses and operatinglosses that we have incurred in each fiscal quarter

 

8

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since our formation. We anticipate that our operatingcosts and expenses will increase for the foreseeable future as we continue toemphasize our research and development, marketing, services and salesoperations. Accordingly, we are likely to continue to experience losses andnegative cash flows from operations in future quarters. We cannot assure youwhen or if we will achieve profitability or, if achieved, that we will be ableto sustain profitability. Our operating results have varied significantly fromquarter to quarter and may continue to do so in the future. As a result, webelieve that period-to-period comparisons of our operating results are notnecessarily meaningful, and you should not rely on them as an indication of ourfuture performance. 

 

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

 

**Sourcesof Revenue and Revenue Recognition Policy**

 

We generate a majority ofour revenues from software license fees. Most of our software license feesoriginate from the marketing efforts of our resellers, who are authorized toplace software orders with us on behalf of end-user customers. We shareend-user customer software license fees with these resellers in varyingpercentages of our list price, according to the terms of their reselleragreements. In addition to generating software license fees indirectly throughresellers, we also receive some software license fees from end-user customersthat we contract with directly. 

 

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

 

• persuasiveevidence of an arrangement exists, 

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

• the fee isfixed or determinable, and 

• collectionis probable. 

 

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

 

We also generate revenues from services that weprovide to our resellers and end-user customers. Services revenues includeproduct maintenance revenues, which consist of technical support and productupgrades, educational services and professional services. Our initial softwarelicense generally includes one year of maintenance. Generally, to continueusing our software after this initial period, our end-user customers mustpurchase annual ongoing product maintenance, which is priced at approximately18% of the current list price of the licensed product. We share maintenance revenueswith those resellers who provide first-level technical support according to theterms of their reseller agreements. When these revenues are shared withresellers, we typically receive between 50% and 70% of the amount charged tothe end-user customer. We recognize product maintenance revenues on astraight-line basis over the term of the initial software license and eachsubsequent annual product maintenance purchase. Revenues from educationalservices, which consist of training courses for resellers and end-usercustomers, and professional services, which include implementing andcustomizing our products for an end-user customer, are typically recognized asthe related services are performed. 

 

9

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*HistoricalResults of Operations*

 

The following table presents certain financial data,derived from our unaudited statements of operations, as a percentage of totalrevenues for the periods indicated.  Theoperating results for the three and six months ended June 30, 2002 and 2001 arenot necessarily indicative of the results that may be expected for the fullyear or for any future period.

 

 
|                            |   | **Three  months ended  June 30,** |   | **Six months  ended  June 30,** |   |
|---------------------------------|--------|-----------------------------------|--------|---------------------------------|--------|
|                            |   | **2002**                          |   | **2001**                        |   | **2002** |   | **2001** |   |
| Revenues:                       |   |                              |   |                            |   |   |   |   |   |
| Software                        |   | 61                                | %      | 66                              | %      | 60 | % | 68 | % |
| Services                        |   | 39                                |   | 34                              |   | 40 |   | 32 |   |
| Total revenues                  |   | 100                               |   | 100                             |   | 100 |   | 100 |   |
|                            |   |                              |   |                            |   |   |   |   |   |
| Costs and  expenses:            |   |                              |   |                            |   |   |   |   |   |
| Costs of  software              |   | 2                                 |   | 1                               |   | 3 |   | 1 |   |
| Costs of  services              |   | 25                                |   | 29                              |   | 27 |   | 29 |   |
| Sales and  marketing            |   | 45                                |   | 46                              |   | 48 |   | 44 |   |
| Research and  development       |   | 33                                |   | 31                              |   | 35 |   | 31 |   |
| General and  administrative     |   | 12                                |   | 16                              |   | 13 |   | 14 |   |
| Special charge                  |   | 6                                 |   | —                          |   | 3 |   | — |   |
| Total costs and  expenses       |   | 123                               |   | 123                             |   | 129 |   | 119 |   |
|                            |   |                              |   |                            |   |   |   |   |   |
| Operating loss                  |   | (23                               | )      | (23                             | )      | (29 | ) | (19 | ) |
| Interest income  (expense), net |   | 1                                 |   | 2                               |   | 1 |   | 3 |   |
| Loss before  income taxes       |   | (22                               | )      | (21                             | )      | (28 | ) | (16 | ) |
| Income taxes                    |   | 1                                 |   | —                          |   | 1 |   | 1 |   |
| Net loss                        |   | (23                               | )%     | (21                             | )%     | (29 | )% | (17 | )% |

 

*Revenues*

 

Our total revenues decreased 11% from $12.7 millionfor the three months ended June 30, 2001 to $11.4 million for the three monthsended June 30, 2002.  Total revenuesdecreased 14% from $25.4 million for the six months ended June 30, 2001, to$21.8 million for the six months ended June 30, 2002.  Non-North American revenues decreased from  $2.3 million and $6.0 million for the threeand six months ended June 30, 2001 respectively, to $1.4 million and $3.0million for the three and six months ended June 30, 2002 respectively.  Our revenues are derived primarily fromlicense fees and fees for services, including product maintenance, educationservices, and professional services. The decrease in total revenues resultedfrom lower software revenues.  While itis difficult to project revenues in the current economic environment, weanticipate software revenues will continue to represent the majority of ourrevenues for the foreseeable future. 

 

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

 

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

 

### *Cost and Expenses*

 

### *Our total costs and expenses decreased11% from $15.7 million for the three months ended June 30, 2001, to $14 millionfor the three months ended June 30, 2002. Similarly, total costs and expenses decreased 7% from $30.3 million forthe six months ended June 30, 2001, to $28.2 million for the six months endedJune 30, 2002.  The decrease in amountwas primarily due to the result of the implementation of our restructuringplans to reduce expenses, as well as lower revenues and increased operatingefficiencies.*

 

*Costsof Software*.  Costs of software consist primarily ofproduct royalties paid to third-parties for the use of their technologies inour products and, to a lesser extent, software packaging costs, which includeproduct media, duplication and documentation. Costs of software increased from $154,000 for the three months endedJune 30, 2001, to $250,000 for the three months ended June 30, 2002.  Costs of software increased from $303,000for the six months ended June 30, 2001 to $578,000 for the six months endedJune 30, 2002.  This represents 2% ofsoftware revenues for the three months and six months ended June 30, 2001, and4% for the three months and six months ended June 30, 2002.  The dollar increase was due to royaltiesowed as a result of additional licensing of third-party technology associated with the releases of our InteractionCenter PlatformTM products and other related products. We expect productroyalties to continue to increase as we release additional products, releaseadditional versions of our existing products, and integrate additionalthird-party software functions and features into our product offerings.

* *

*Costsof Services.*  Costs of services consist primarily ofcompensation expenses for technical support, education, and professionalservices personnel and other costs associated with supporting our resellers andend-user customers.  Costs of servicesdecreased from $3.7 million for the three months ended June 30, 2001, to $2.9million for the three months ended June 30, 2002.  Costs of services decreased from $7.3 million for the six monthsended June 30, 2001, to $5.9 million for the six months ended June 30,2002.  As a percentage of servicesrevenues, cost of services represented 85% and 65% for the three months ended June30, 2001 and 2002, respectively, and 90% and 67% for the six months ended June30, 2001 and 2002, respectively. The dollar decrease is the result of areduction in employees and expenditures as part of our restructuring plans,lower outsourced services, as well as increased operating efficiencies.

 

*Salesand Marketing.*  Sales and marketing expenses consist oftrade shows, advertising, telemarketing campaigns, public relations and otherpromotional expenses, compensation expenses (including sales commissions), andtravel expenses.  Sales and marketingexpenses decreased from $5.9 million for the three months ended June 30, 2001,to $5.1 million for the three months ended June 30, 2002.  Sales and marketing expenses decreased from$11.3 million for the six months ended June 30, 2001 to $10.6 million for thesix months ended June 30, 2002.  Thedecrease is the result of a reduction in employees and marketing programexpenditures following the implementation of our restructuring plans, anddecreased commissions due to lower sales. As we continue to focus on salesgrowth and develop awareness for our products, we plan to continue investingsignificantly in sales and marketing efforts. 

 

*Researchand Development.* Research and development expenses consist primarily of compensationexpenses for our developers and third party efforts to develop and enhance ourproducts; including adapting our products for specific non-English languagesand allowing our products to effectively run with alternative hardwareconfigurations.  Research anddevelopment expenses decreased from $3.9 million for

 

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the three months ended June 30, 2001, to $3.7 million for the threemonths ended June 30, 2002.   Researchand development expenses decreased from $7.8 million for the six months endedJune 30, 2001, to $7.6 million for the six months ended June 30, 2002.Currently, all costs related to research and development of our products arecharged to research and development expense as incurred. These decreases arethe results of a reduction in employees following the implementation of ourrestructuring plans.  We believe that asignificant investment in research and development has been, and will continueto be, critical to market acceptance of our products.

 

*Generaland Administrative.* General and administrative expenses consist primarily of compensationfor our administrative, financial, and information technology personnel, and anumber of non-allocable costs, including legal and other professional servicefees. General and administrative expenses decreased from $2.0 million for thethree months ended June 30, 2001, to $1.4 million for the three months endedJune 30, 2002.  General andadministrative expenses decreased from $3.6 million for the six months endedJune 30, 2001 to $2.9 million for the six months ended June 30, 2002.  The decreases are primarily due to lower baddebt expense and savings associated with our restructuring initiatives taken,including lower staffing levels and cost controls.

 

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

 

*Interest income, net*

 

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

 

*Income taxes*

 

For U.S. corporate income tax purposes, we did notrecognize a tax benefit related to U.S. federal or state income taxes duringthe three months or six months ended June 30, 2001 or June 30, 2002 because ofthe uncertainty of eventually realizing these benefits.  However, we did recognize a tax expenserelated to our international operations of $60,000 for the three months endedJune 30, 2002, and $129,000 for the six months ended June 30, 2002.

 

*Liquidity and Capital Resources*

 

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

 

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

 

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

 

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

 

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

 

Our investing activitieshave consisted primarily of capital expenditures for property and equipment andpurchases and sales of investments. Our activities resulted in a $6.5 millionoutflow for the six months period ended June 30, 2002 and a $9.2 millionoutflow for the six months period ended June 30, 2001. The difference in cashoutflow between the first six months of 2001 and 2002 was attributed to lessnet purchases of available-for-sale investments and capital expenditures forproperty and equipment. At June 30, 2002, we did not have any materialcommitments for future capital expenditures. 

 

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

 

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

 

At June 30, 2002, we hadno amounts outstanding on our line of credit and were in compliance with allrelated covenants and restrictions. This line of credit expired on June 22,2002.  We did not renew the line ofcredit. 

 

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

 

*FactorsAffecting Operating Results*

** **

**OURLIMITED OPERATING HISTORY MAKES FINANCIAL FORECASTING DIFFICULT AND, IN****ASSESSINGOUR PROSPECTS, YOU SHOULD CONSIDER OUR EARLY STAGE OF DEVELOPMENT AND****PRESENCEIN A NEW AND RAPIDLY EVOLVING INDUSTRY**

 

Our limited operating history makes it difficult toforecast our future operating results. We commenced operations in October 1994,but did not begin shipping an Interaction Center Platformä-basedproduct until 1997.  In 1999, we beganshipping Interaction Recorderâ, InteractionDialerTM, and e-FAQTM. Accordingly, you should assess our prospects in light ofthe risks and difficulties frequently encountered by companies in the earlystage of development, particularly companies in new and rapidly evolvingindustries. 

 

**WE HAVEHISTORICALLY INCURRED LOSSES AND WE MAY NOT ACHIEVE PROFITABILITY**

 

We have not operated profitably to date. We incurrednet losses of $9.0 million, $4.6 million, and $7.1 million in 2001, 2000, and1999, respectively. At June 30, 2002, we had accumulated losses since inceptionof $41.7 million. We intend to continue to make significant investments in ourresearch and development, marketing, services and sales operations. Weanticipate that these expenses could significantly precede any revenuesgenerated by the increased spending. As a result, we may continue to experiencelosses and negative cash flow from operations in future quarters. If we dobecome profitable, we may not sustain or increase our profitability.

 

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**OURQUARTERLY OPERATING RESULTS HAVE VARIED SIGNIFICANTLY AND, IF SEVERAL****FACTORSAFFECTING OUR BUSINESS CAUSE THEM TO CONTINUE TO DO SO, THE MARKET PRICE OF OURCOMMON STOCK COULD BE AFFECTED**

 

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

 

Because we do not know when our potential end-usercustomers will place orders and finalize contracts, we cannot accuratelyforecast our revenues and operating results for future quarters. We recognizerevenues on satisfaction of the requirements of AICPA Statement of Position97-2, which generally occurs in the same quarter that the order is received. Asa result, our quarterly revenues and operating results depend primarily on thesize, quantity and timing of orders received for our products during eachquarter. If a large number of orders or several large orders do not occur orare deferred or delayed, our revenues in a quarter could be substantiallyreduced. This risk is heightened by the significant investment and executivelevel decision making typically involved in our end-user customers' decisionsto license our products. Since a large portion of our operating expenses,including rent and salaries, is fixed and difficult to reduce or modify, ourbusiness, financial condition or results of operations could be materiallyadversely affected if revenues do not meet our expectations. 

 

Because of our early stage of development and limitednumber of products, changes in pricing policies and the timing of thedevelopment, announcement and sale of new or upgraded versions of our productsare some of the additional factors that could cause our revenues and operatingresults to vary significantly from quarter to quarter. 

 

**WE HAVEA LENGTHY PRODUCT SALES CYCLE, WHICH HAS CONTRIBUTED, AND MAY CONTINUE****TOCONTRIBUTE, TO THE QUARTER-TO-QUARTER VARIABILITY OF OUR REVENUES AND****OPERATINGRESULTS, WHICH COULD AFFECT THE MARKET PRICE OF OUR COMMON STOCK**

 

We have generally experienced a lengthy product salescycle, averaging approximately six to nine months. The lengthy sales cycle isone of the factors that has caused, and may in the future continue to cause,our software revenues and operating results to vary significantly from quarterto quarter, which could affect the market price of our common stock. It alsomakes it difficult for us to forecast product license revenues. Because of theunique characteristics of our products, our prospective end-user customers'decisions to license our products often require significant investment andexecutive level decision making. We believe that many companies currently arenot aware of the benefits of interaction management software of the type welicense or of our products and capabilities. For this reason, we must provide asignificant level of education to prospective end-user customers about the useand benefits of our products, which can cause potential end-user customers totake many months to make these decisions. As a result, sales cycles forend-user customer orders vary substantially from customer to customer. Excessivedelay in product sales could materially adversely affect our business,financial condition or results of operations. 

 

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

 

•an end-user customer's budgetary constraints; 

 

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

 

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

 

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

 

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In addition, the sales cycle for our products in international marketshas been, and is expected to continue to be, longer than the sales cycle in theUnited States. The average sales cycle for our products may lengthen as weexpand internationally. 

 

**OURINABILITY TO MANAGE SUCCESSFULLY OUR INCREASINGLY COMPLEX****THIRD PARTYRELATIONSHIPS COULD ADVERSELY AFFECT US**

 

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

 

**WE FACECOMPETITIVE PRESSURES, WHICH MAY HAVE A MATERIAL ADVERSE EFFECT ON US**

 

The market for our software products is highlycompetitive and, because there are relatively low barriers to entry in thesoftware market, we expect competition to increase significantly in the future.In addition, because our industry is new and evolving and characterized byrapid technological change, it is difficult for us to predict whether, when andby whom new competing technologies or new competitors may be introduced intoour markets. Currently, our competition comes from several different marketsegments, including computer telephony platform developers, computer telephonyapplications software developers, telecommunications equipment vendors and datanetworking equipment vendors. We cannot assure you that we will be able tocompete effectively against current and future competitors. In addition,increased competition or other competitive pressures may result in pricereductions, reduced margins or loss of market share, any of which could have amaterial adverse effect on our business, financial condition or results ofoperations. 

 

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

 

**WE MAYNOT BE ABLE TO GROW OUR BUSINESS IF WE DO NOT MAINTAIN****SUCCESSFULRELATIONSHIPS WITH OUR RESELLERS AND OEM PARTNERS AND CONTINUE TO RECRUIT ANDDEVELOP****ADDITIONAL SUCCESSFUL RESELLERS AND OEM PARTNERS**

 

Our ability to achieve revenue growth in the futurewill depend in part on our success in maintaining successful relationships withour existing and future resellers and OEM partners and in recruiting andtraining additional resellers and OEM partners. We rely primarily on resellersto market and support our products, and plan on relying more on our OEMpartners in the future. We are still developing and refining our reseller andOEM distribution networks and may be unable to attract additional resellerswith both voice and data expertise or appropriate OEM partners that will beable to market our products effectively and that will be qualified to providetimely and cost-effective customer support and service. We generally do nothave long-term or exclusive agreements with our resellers or OEM partners, andthe loss of specific larger resellers or OEM partners or a significant numberof resellers or OEM partners could materially adversely affect our business,financial condition or results of operations. 

 

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**OURMARKETS ARE CHARACTERIZED BY RAPID TECHNOLOGICAL CHANGE WHICH MAY CAUSE US****TO INCURSIGNIFICANT DEVELOPMENT COSTS AND PREVENT US FROM ATTRACTING NEW****CUSTOMERS**

 

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

 

**The growth of our business may be impeded without increaseduse of the Internet**

 

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

** **

**Our business will be adversely affected if web–basedelectronic business solutions are not widely adopted**

 

Our products address a relatively new and emergingmarket for Web–based, interactive electronic business solutions.Therefore, our future success depends on the widespread adoption of the Web asa primary medium for commerce and business applications. The failure of thismarket to develop, or a delay in the development of this market, could have amaterial adverse effect on our business, financial condition or results ofoperations. The Web has experienced, and is expected to continue to experience,significant user and traffic growth, which has, at times, caused userfrustration with slow access and download times. The Web infrastructure may notbe able to support the demands placed on it by the continued growth on whichour success depends. Moreover, critical issues concerning the commercial use ofthe Web, such as security, reliability, cost, accessibility and quality ofservice, remain unresolved and may negatively affect the growth of Web use orthe attractiveness of commerce and business communication over the Web. In addition,the Web could lose its viability due to delays in the development or adoptionof new standards and protocols to handle increased activity or due to increasedgovernment regulation and taxation of Internet commerce. 

** **

**ADECLINE IN MARKET ACCEPTANCE FOR MICROSOFT CORPORATION TECHNOLOGIES ON WHICH****OURPRODUCTS RELY COULD HAVE A MATERIAL ADVERSE EFFECT ON US**

 

Our products currently run only on Microsoft Windows2000® servers. In addition, our products use other Microsoft Corporationtechnologies, including Microsoft Exchange Server® and Microsoft SQL Server®. Adecline in market acceptance for Microsoft technologies or the increasedacceptance of other server technologies could cause us to incur significantdevelopment costs and could have a material adverse effect on our ability tomarket our current products. Although we believe that Microsoft technologieswill continue to be widely used by businesses, we cannot assure you thatbusinesses will adopt these technologies as anticipated or will not in the futuremigrate to other computing technologies that we do not currently support. Inaddition, our products and technologies must continue to be compatible with newdevelopments in Microsoft technologies. 

 

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**OURFUTURE BUSINESS PROSPECTS DEPEND IN PART ON OUR ABILITY TO MAINTAIN AND****IMPROVEOUR CURRENT PRODUCTS AND DEVELOP NEW PRODUCTS**

 

We believe that our future business prospects dependin large part on our ability to maintain and improve our current products andto develop new products on a timely basis. Our products will have to achievemarket acceptance, maintain technological competitiveness and meet an expandingrange of end-user customer requirements. As a result of the complexitiesinherent in our products, major new products and product enhancements requirelong development and testing periods. We may not be successful in developingand marketing, on a timely and cost effective basis, product enhancements ornew products that respond to technological change, evolving industry standardsor end-user customer requirements. We may also experience difficulties thatcould delay or prevent the successful development, introduction or marketing ofproduct enhancements, and our new products and product enhancements may notachieve market acceptance. Significant delays in the general availability ofnew releases of our products or significant problems in the installation orimplementation of new releases of our products could have a material adverseeffect on our business, financial condition or results of operations. 

 

**SLOWGROWTH, OR A DECLINE IN DEMAND FOR INTERACTION MANAGEMENT SOFTWARE OF THE TYPEWE****LICENSE, COULD MATERIALLY ADVERSELY AFFECT OUR GROWTHPROSPECTS**

 

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

 

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

 

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

 

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

 

Our products cannot currently meet the communicationsneeds of organizations with more than 500 users at a single call centerlocation.  As these organizations expandto include multiple locations, our products can be customized to increase thenumber of telephone lines, extensions and users. We will need to adapt oursoftware to serve larger single–site organizations.  Although we are currently developing andtesting solutions that would enable our software to significantly increase thenumber of users that our products can serve at a single location, we cannotassure you that we will be able to successfully introduce this technology intoa currently available version of our products.  Further, we may not be able to adapt our software in a timely orcost effective manner in a way that will permit us to

 

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

** **

**Our mainsuppliers of voice processing boards may become unwilling or unable to continueto manufacture and supply us with voice processing boards, requiring us tointroduce a substitute supplier which could prove difficult or costly**

 

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

 

In addition, Dialogic Corporation’s CT MediaTM  server software offers some of thefunctionality that our Interaction Center Platformäproducts provide and consequently could make it easier for competitors orpotential competitors to provide products competitive with ours. If CT MediaTMserver software were to become an industry standard, our failure to adopt itcould disadvantage us in competitive situations.  In addition, although neither of our primary suppliers of voiceprocessing boards nor their affiliates currently offer a product that competeswith our Interaction Center Platformä products, theycould potentially develop a competitive or superior product.

 

**WE MAYNOT BE ABLE TO PROTECT OUR PROPRIETARY RIGHTS ADEQUATELY, WHICH COULD****ALLOWTHIRD PARTIES TO COPY OR OTHERWISE OBTAIN AND USE OUR TECHNOLOGY WITHOUT****AUTHORIZATION**

 

We regard our software products as proprietary. In aneffort to protect our proprietary rights, we rely primarily on a combination ofcopyright, trademark and trade secret laws, as well as licensing and otheragreements with consultants, suppliers, strategic and OEM partners, resellersand end–user customers, and employee and third–party non–disclosureagreements. These laws and agreements provide only limited protection of ourproprietary rights. In addition, we have not signed agreements containing thesetypes of protective provisions in every case, and the contractual provisionsthat are in place and the protection they provide vary and may not provide uswith adequate protection in all circumstances. We have filed patentapplications directed to several inventions embodied in our softwareproducts.  We currently hold one patent.We hold eight U.S. trademark registrationsand 21 foreign trademark registrations, and have numerous other trademarkapplications pending worldwide, as well as having common law rights in othertrademarks and service marks.  Wehold one registered copyright. Because our means of protecting our proprietaryrights may not be adequate, it may be possible for a third party to copy orotherwise obtain and use our technology without authorization. A third partycould also develop similar technology independently. In addition, the laws ofsome countries in which we sell our products do not protect our software andintellectual property rights to the same extent as the laws of the UnitedStates. Unauthorized copying, use or reverse engineering of our products couldmaterially adversely affect our business, results of operations or financialcondition. 

 

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

 

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**INFRINGEMENTCLAIMS COULD ADVERSELY AFFECT US**

 

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

 

In June 2000 and October 2001, we received letters from a competitor inthe outbound call center market claiming that our products utilize technologiespioneered and patented by the competitor. Although our patent counsel has not determined the validity orapplicability of these patents, we have discussed the possible licensing ofcertain technologies from the competitor. We cannot assure you that these claims can be resolved amicably withoutlitigation, or that we will be able to enter into licensing arrangements onterms and conditions that would not have a material adverse effect on ourbusiness, financial condition or results of operations. 

 

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

 

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

 

Other third parties could claim that our technologyinfringes their proprietary rights. As the number of software products in ourtarget markets increases and the functionality of these products overlap, webelieve that software developers may face infringement claims. For example,various patent rights have been asserted against interfaces between PBXhardware and computer network systems. Although we believe that our products donot infringe any of these patents because, among other reasons, our products aredesigned to replace PBXs and not to create such interfaces, if these patentswere interpreted broadly, claims of infringement of these patents could have amaterial adverse affect on us. 

 

Infringement claims, even if without merit, can betime consuming and expensive to defend. A third party asserting infringementclaims against us or our customers with respect to our current or futureproducts may require us to enter into costly royalty arrangements orlitigation, or otherwise materially adversely affect us.

 

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

 

Our success depends in large part on the continuedservice of our key personnel, particularly Dr. Donald E. Brown, our ChiefExecutive Officer and principal stockholder. The loss of the services of  Dr.Donald E Brown or any key personnel could have a material adverse effect on ourbusiness, financial condition or results of operations.  We do not have key man life insurance on anyof our employees.  Our future successalso depends on our ability to attract, train, assimilate and retain additionalqualified personnel. Competition for persons with skills in the softwareindustry is intense, particularly for those with relevant technical and/orsales experience. We cannot assure you that we will be able to retain our keyemployees or that we can attract, train, assimilate or retain other highlyqualified personnel in the future.

 

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**OURWORKFORCE REDUCTION AND FINANCIAL PERFORMANCE MAY ADVERSELY AFFECT THE MORALEAND PERFORMANCE OF OUR PERSONNEL AND OUR ABILITY TO HIRE NEW PERSONNEL**

 

In connection with our effort to streamlineoperations, reduce costs and rationalize our staffing and structure, we had areduction in both 2001 and April 2002 of our worldwide workforce ofapproximately 10% each.  There were andmay continue to be substantial costs associated with the workforce reductionsrelated to severance and other employee-related  costs, and our restructuring plans may still yield unanticipatedconsequences, such as attrition beyond our implemented reduction in workforce.  As a result, our ability to respond tounexpected challenges may be impaired and we may be unable to take advantage ofnew opportunities. The reduction in workforce may reduce employee morale andmay create concern among existing employees about job security, which may leadto increased turnover.  These reductionsin headcount may still subject us to the risk of litigation.  In addition, recent trading levels of ourcommon stock have decreased the value of the stock options granted to employeespursuant to our stock option plans.  Asa result of these factors, our remaining personnel may seek employment withlarger, more established companies or companies they perceive as having lessvolatile stock prices.

** **

**WE MAYPURSUE ACQUISITIONS THAT BY THEIR NATURE PRESENT RISKS AND THAT MAY NOT****BESUCCESSFUL**

 

In the future we may pursue additional acquisitions todiversify our product offerings and customer base or for other strategicpurposes. We have no prior history of making material acquisitions and wecannot assure you that any future acquisitions will be successful. The followingare some of the risks associated with acquisitions that could have a materialadverse effect on our business, financial condition or results of operations: 

 

•                  We cannot assurethat any acquired businesses will achieve anticipated revenues, earnings or cashflow. 

 

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

 

•                  Acquisitionscould disrupt our ongoing business, distract management, divert resources andmake it difficult to maintain our current business standards, controls andprocedures. 

 

•                  We may financefuture acquisitions by issuing common stock for some or all of the purchaseprice. This could dilute the ownership interests of our stockholders. We mayalso incur additional debt or be required to recognize amortization expenserelated to goodwill and other intangible assets purchased in futureacquisitions. 

 

•                  We would becompeting with other firms, many of which have greater financial and otherresources, to acquire attractive companies. We believe this competition willincrease, making it more difficult to acquire suitable companies on acceptableterms. 

 

**OURINTERNATIONAL OPERATIONS AND EXPANSION INVOLVE FINANCIAL AND OPERATIONAL****RISKS**

 

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

 

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•                  economic andpolitical instability; 

 

•                  unexpectedchanges in foreign regulatory requirements and laws; 

 

•                  tariffs andother trade barriers; 

 

•                  timing, cost andpotential difficulty of adapting our software products to the local language inthose foreign countries that do not use the alphabet that English uses, such asJapan, Korea and China; 

 

•                  lack ofacceptance of our products in foreign countries; 

 

•                  longer salescycles and accounts receivable payment cycles; 

 

•                  potentiallyadverse tax consequences; and 

 

•                  restrictions onthe repatriation of funds. 

 

**FLUCTUATIONSIN THE VALUE OF FOREIGN CURRENCIES COULD RESULT IN LOSSES**

 

Our international revenues are generally denominatedin U.S. Dollars, but our international expenses are generally denominated inlocal foreign currencies. Although foreign currency translation gains andlosses have been immaterial to date, fluctuations in exchange rates between theU.S. Dollar and other currencies could have a material adverse effect on ourbusiness, financial condition or results of operations, and particularly on ouroperating margins. To date, we have minimally sought to hedge the risksassociated with fluctuations in exchange rates, but we may more activelyundertake to do so in the future. Any hedging techniques we implement in thefuture may not be successful. Exchange rate fluctuations could also make ourproducts more expensive than competitive products not subject to thesefluctuations, which could adversely affect our revenues and profitability ininternational markets. 

** **

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

 

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

 

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

 

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

 

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

 

**We may not be able to obtain adequate financing to implementour strategy **

** **

Successful implementation of our strategy may requirecontinued access to capital. If we do not generate sufficient cash fromoperations, our growth could be limited unless we are able to obtain capitalthrough additional debt or equity financings. We cannot assure you that debt orequity financings will be available as required for acquisitions or otherneeds. Even if financing is available, it may not be on terms that arefavorable to us or sufficient for our needs. If we are unable to obtainsufficient financing, we may be unable to fully implement our growth strategy. 

** **

**OURSTOCK PRICE HAS BEEN AND COULD CONTINUE TO BE HIGHLY VOLATILE**

 

Our stock price has been highly volatile.  This volatility may be heightened becauseour industry is new and evolving, characterized by rapid technological changeand susceptible to the introduction of new competing technologies orcompetitors.

 

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

 

•   actual or anticipated fluctuations in ouroperating results; 

 

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

 

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

 

•   technological innovations by others; 

 

•   the operating and stock price performanceof other comparable companies or of our competitors or end–usercustomers;

 

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

 

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

 

•   general market or economic conditions. 

 

In addition, the stockmarket has experienced significant price and volume fluctuations that haveparticularly affected the trading prices of equity securities of manytechnology companies, including us. These price and volume fluctuations oftenhave been unrelated to the operating performance of the affected companies. Inthe past, following periods of volatility in the market price of a company’ssecurities, securities class action litigation has often been institutedagainst that company. This type of litigation, regardless of the outcome, couldresult in substantial costs and a diversion of management’s attention andresources, which could materially and adversely affect our business, financialcondition or results of operations. 

** **

**A CONTINUED DECLINE IN CAPITALSPENDING COULD HAVE A MATERIAL ADVERSE EFFECT ON US**

** **

Our products typicallyrepresent substantial capital commitments by customers, involving a potentiallylong sales cycle.  As a result, customerpurchase decisions may be significantly affected by a variety of factorsincluding trends in capital spending for telecommunications, enterprisesoftware, market competition, and the availability or announcement ofalternative technologies.  Continuedrecent weakness in global economic conditions has resulted in many of ourcustomers delaying and/or reducing their capital spending related toinformation systems.  If the economycontinues to be weak, demand for our products could decrease resulting in lowerrevenues and a decline in the overall rate of the our revenue levels.

** **

**Item 3. Quantitative and Qualitative Disclosures about MarketRisk.**

 

We develop products in the United States and selllicenses in North America, Europe, the Asia/Pacific region, South Africa, andCentral and South America. As a result, our financial results could be affectedby

 

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

 

We manage our interest rate risk by maintaining aninvestment portfolio with debt instruments of high credit quality andrelatively short average maturities. We also manage interest rate risk bymaintaining sufficient cash and cash equivalent balances such that we aretypically able to hold our investments to maturity.

 

**P**ARTII. OTHER INFORMATION

 

**Item 1. Legal Proceedings.**

 

In June 1999 andSeptember 1999, the Company received letters from a competitor in the callcenter market claiming that the Company's products utilize technologiespioneered and patented by that competitor. The Company's patent counsel has reviewed all of the patents listed inthe letters.  Based on the advice of theCompany's patent counsel, the Company believes that its products do notinfringe any of the patents listed in either letter.  The Company has discussed its conclusion with the competitor andhas also discussed possible licensing of certain technologies from thecompetitor.  The Company cannot assureyou that this matter can be resolved amicably without litigation, or that itwill ultimately be able to enter into a licensing arrangement on terms andconditions that would not have a material adverse effect on the Company'sbusiness, financial condition or results of operations.

 

In June 2000 and October2001, the Company received letters from a competitor in the outbound callcenter market claiming that the Company's products utilize technologiespioneered and patented by the competitor. Although the Company's patent counsel has not determined the validity orapplicability of these patents, the Company has discussed the possiblelicensing of certain technologies from the competitor.  The Company cannot assure you that these claimscan be resolved amicably without litigation, or that it will be able to enterinto licensing arrangements on terms and conditions that would not have amaterial adverse effect on the Company's business, financial condition orresults of operations.

 

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

 

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

 

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

 

From time to time, theCompany is also involved in certain legal proceedings in the ordinary course ofconducting our business.  While theultimate liability pursuant to these actions cannot currently be determined,none is expected to be material to our results of operations, financialcondition or cash flows.

 

**Item4.  Submissions of Matters to Vote ofSecurity Holders**

** **

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

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

 

**Item6. Exhibits and Reports on Form 8-K.**

 

(a)    Exhibits

10.17 (iii) Modificationand /or Extension Agreement, dated April 29, 2002, between the Company andKeyBank

 

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

 

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

 

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

 

 

(b)    Reports on Form 8-K

                Noreports on Form 8-K were filed during the quarter covered by this Form 10-Q.

 

 

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**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 theundersigned thereunto duly authorized. 

 
|                  | Interactive Intelligence, Inc.                                  |         |
|-----------------------|-----------------------------------------------------------------|--------------|
|                  |                                                            | (Registrant) |
|                  |                                                            |         |
| Date: August 13, 2002 | By  /s/ Keith  A. Midkiff                                  |         |
|                  |                                                            |         |
|                  | Keith A. Midkiff                                                |         |
|                  | Chief Financial Officer, Secretary and Treasurer                |         |
|                  | (Principal Financial Officer and Principal  Accounting Officer) |         |
|                       |                                                                 |              |  |  |

 

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