**UNITED
      STATES**


**SECURITIES
      AND EXCHANGE COMMISSION**





**Washington,
      D.C. 20549**





**____________**





**FORM
      10-Q**


**(Mark
      One)**





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





**For
      the quarterly period ended March 31, 2006**





**Or**





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





**For
      the transition period from ____________to____________**





**Commission
      File Number 000-27385**










**INTERACTIVE
      INTELLIGENCE, INC.**


**(Exact
      name of registrant as specified in its charter)**





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





**7601
      Interactive Way**


**Indianapolis,
      Indiana 46278**


**(Address
      of principal executive offices)**





**(317)
      872-3000**


**(Registrant's
      telephone number)**





Indicate
      by checkmark whether the registrant (1) has filed all reports required to be
      filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
      the
      preceding 12 months (or for such shorter period that the registrant was required
      to file such reports), and (2) has been subject to such filing requirements
      for
      the past 90 days.  Yes**T**No*****




Indicate
        by check mark whether the registrant is a large accelerated filer, an
        accelerated filer or a non-accelerated filer. See definition of “accelerated
        filer and large accelerated filer" as defined in Rule 12b-2 of the Exchange
        Act.  Large
        accelerated filer  *****  Accelerated
        filer ***** **** Non-accelerated
        filer  **T**





Indicate
      by check mark whether the registrant is a shell company (as defined in Rule
      12b-2 of the Exchange Act).  Yes  *****  No  **T**





The
      number of shares of common stock
      outstanding on April 30, 2006 was 16,413,305.






Table
          of Contents


TABLE
      OF CONTENTS








PART
      I.
      FINANCIAL INFORMATION


Item
                  1.
              Condensed
                  Consolidated Balance Sheets as of March 31, 2006 and
                  December 31, 2005
              1Condensed
                  Consolidated Statements of Income for the three
                  months ended March 31, 2006 and 2005
              2Condensed
                  Consolidated Statement of Shareholders’ Equity for
                  the three months ended March 31, 2006
              3Condensed
                  Consolidated Statements of Cash Flows for the three
                  months ended March 31, 2006 and 2005
              4Notes
                  to Condensed Consolidated Financial
                  Statements
              5Item
                  2.
              Management's
                  Discussion and Analysis of Financial Condition
                  and Results of Operations
              10Item
                  3.
              Quantitative
                  and Qualitative Disclosures About Market
                  Risk
              17Item
                  4.
              Controls
                  and Procedures
              17PART
                  II. OTHER INFORMATIONItem
                  1.
              Legal
                  Proceedings
              17Item
                  1A.
              Risk
                  Factors
              18Item
                  6.
              Exhibits
              18SIGNATURES
              19


Table
          of Contents


**PART
      I. FINANCIAL INFORMATION**





**Item
      1.** **Condensed Consolidated Financial Statements and
      Footnotes.**


**Interactive
      Intelligence, Inc.**


**Condensed
      Consolidated Balance Sheets**


**As
      of March 31, 2006 and December 31, 2005**


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


**March
                  31,**
                **2006**
              
              **December
                  31,**
                **2005****(unaudited)**
              
              **(Note
                  1)****Assets**Current
                  assets:Cash
                  and cash equivalents
              
              $
              14,066
              
              $
              11,551Short-term
                  investments
              
              
              4,803
              
              
              3,576Accounts
                  receivable, net of allowance for doubtful accounts of $483 in 2006
                  and
                  $652 in 2005
              
              
              14,130
              
              
              14,927Prepaid
                  expenses
              
              
              3,988
              
              
              2,939Other
                  current assets
              
              
              935
              
              
              789Total
                  current assets
              
              
              37,922
              
              
              33,782Property
                  and equipment, net
              
              
              4,069
              
              
              4,013Other
                  assets, net
              
              
              612
              
              
              603Total
                  assets
              
              $
              42,603
              
              $
              38,398**Liabilities
                  and Shareholders’ Equity**Current
                  liabilities:Accounts
                  payable and accrued liabilities
              
              $
              6,567
              
              $
              6,676Accrued
                  compensation and related expenses
              
              
              1,753
              
              
              1,906Deferred
                  product revenues
              
              
              5,930
              
              
              5,195Deferred
                  services revenues
              
              
              18,136
              
              
              16,828Total
                  current liabilities
              
              
              32,386
              
              
              30,605Shareholders’
                  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; 16,374,026 issued
                  and
                  outstanding at March 31, 2006, 16,120,543 issued and outstanding
                  at
                  December 31, 2005
              
              
              164
              
              
              161Additional
                  paid-in capital
              
              
              67,235
              
              
              65,826Accumulated
                  deficit
              
              
              (57,182
              )
              
              (58,194
              )Total
                  shareholders’ equity
              
              
              10,217
              
              
              7,793Total
                  liabilities and shareholders’ equity
              
              $
              42,603
              
              $
              38,398





See
      Accompanying Notes to Condensed Consolidated Financial
      Statements


1
 Table
          of Contents





**Interactive
      Intelligence, Inc.**


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


**For
      the Three Months Ended March 31, 2006 and 2005**


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





**Three
                Months Ended**
              **March
                31,****2006**
            
            **2005**Revenues:Product
            
            $
            8,861
            
            $
            7,886Services
            
            
            9,069
            
            
            6,707Total
                revenues
            
            
            17,930
            
            
            14,593Cost
                of revenues:Product
            
            
            1,333
            
            
            766Services
            
            
            3,144
            
            
            2,707Total
                cost of revenues
            
            
            4,477
            
            
            3,473Gross
                profit
            
            
            13,453
            
            
            11,120Operating
                expenses:Sales
                and marketing
            
            
            6,879
            
            
            5,854Research
                and development
            
            
            3,041
            
            
            3,195General
                and administrative
            
            
            2,534
            
            
            2,021Total
                operating expenses
            
            
            12,454
            
            
            11,070Operating
                income
            
            
            999
            
            
            50Other
                income:Interest
                income, net
            
            
            104
            
            
            51Other
                expense, net
            
            
            (52
            )
            
            (46
            )Total
                other income
            
            
            52
            
            
            5Income
                before income taxes
            
            
            1,051
            
            
            55Income
                taxes
            
            
            39
            
            
            30Net
                income
            
            $
            1,012
            
            $
            25Net
                income per share:Basic
            
            $
            0.06
            
            $
            0.00Diluted
            
            
            0.06
            
            
            0.00Shares
                used to compute net income per share:Basic
            
            
            16,251
            
            
            15,958Diluted
            
            
            17,178
            
            
            16,554





See
      Accompanying Notes to Condensed Consolidated Financial
      Statements


2
 Table
          of Contents





**Interactive
      Intelligence, Inc.**


**Condensed
      Consolidated Statement of Shareholders’ Equity (unaudited)**


**For
      the Three Months Ended March 31, 2006**


**(in
      thousands)**





**Common
                Stock**
            
            **Additional**
              **Paid-in**
            
            **Accumulated****Shares**
            
            **Amount**
            
            **Capital**
            
            **Deficit**
            
            **Total**Balances,
                December 31, 2005
            
            
            16,121
            
            $
            161
            
            $
            65,826
            
            $
            (58,194
            )
            $
            7,793Issuances
                of common stock
            
            
            13
            
            
            --
            
            
            57
            
            
            --
            
            
            57Exercise
                of stock options
            
            
            240
            
            
            3
            
            
            859
            
            
            --
            
            
            862Stock-based
                compensation
            
            
            --
            
            
            --
            
            
            493
            
            
            --
            
            
            493Net
                income
            
            
            --
            
            
            --
            
            
            --
            
            
            1,012
            
            
            1,012Balances,
                March 31, 2006
            
            
            16,374
            
            $
            164
            
            $
            67,235
            
            $
            (57,182
            )
            $
            10,217





See
      Accompanying Notes to Condensed Consolidated Financial
      Statements


3
 Table
          of Contents





**Interactive
      Intelligence, Inc.**


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


**For
      the Three Months Ended March 31, 2006 and 2005**


**(in
      thousands)**





**Three
                Months Ended**
              **March
                31,****2006**
            
            **2005****Operating
                activities:**Net
                income
            
            $
            1,012
            
            $
            25Adjustments
                to reconcile net income to net cash provided by operating
                activities:Depreciation
            
            
            430
            
            
            598Stock-based
                compensation expense related to stock options
            
            
            493
            
            
            43Loss
                on disposal of fixed assets
            
            
            2
            
            
            --Changes
                in operating assets and liabilities:Accounts
                receivable
            
            
            797
            
            
            132Prepaid
                expenses
            
            
            (1,049
            )
            
            (800
            )Other
                current assets
            
            
            (146
            )
            
            190Other
                assets
            
            
            (9
            )
            
            (11
            )Accounts
                payable and accrued liabilities
            
            
            (109
            )
            
            (427
            )Accrued
                compensation and related expenses
            
            
            (153
            )
            
            (4
            )Deferred
                product revenues
            
            
            735
            
            
            209Deferred
                services revenues
            
            
            1,308
            
            
            979Net
                cash provided by operating activities
            
            
            3,311
            
            
            934**Investing
                activities:**Purchases
                of property and equipment
            
            
            (488
            )
            
            (566
            )Purchases
                of available-for-sale investments
            
            
            (1,227
            )
            
            --Net
                cash used by investing activities
            
            
            (1,715
            )
            
            (566
            )**Financing
                activities:**Proceeds
                from issuance of common stock
            
            
            57
            
            
            57Proceeds
                from stock options exercised
            
            
            862
            
            
            127Net
                cash provided by financing activities
            
            
            919
            
            
            184Net
                increase in cash and cash equivalents
            
            
            2,515
            
            
            552Cash
                and cash equivalents, beginning of period
            
            
            11,551
            
            
            14,603Cash
                and cash equivalents, end of period
            
            $
            14,066
            
            $
            15,155Cash
                paid for interest
            
            $
            3
            
            $
            1Cash
                paid for taxes
            
            
            93
            
            
            51





See
      Accompanying Notes to Condensed Consolidated Financial Statements





4
 Table
          of Contents


**InteractiveIntelligence,
      Inc.**


**Notes
      To Condensed Consolidated Financial Statements**


**March
      31, 2006 and 2005 (unaudited)**





**1.**
            **The
                Company and Significant Accounting
                Policies**





*The
      Company*




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


·
            Contact
                Centers,


·
            Enterprise
                IP Telephony,


·
            Unified
                Communications, and


·
            Self-service
                Automation.





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





Principal
      operations of the Company commenced during 1994 and initial revenue was
      recognized in 1997. Since then, the Company has established wholly-owned
      subsidiaries in Australia, France, the Netherlands and the United Kingdom,
      and
      in 2004 formed its Vonexus, Inc. (Vonexus) subsidiary for global Enterprise
      IP
      Telephony and Microsoft small and medium sized business customer markets. The
      Company also currently has international branch offices in Canada, Germany,
      Japan, Korea, Malaysia, Singapore and Sweden. The Company markets its software
      applications in the Americas, Europe, the Middle East and Africa (EMEA), and
      Asia/Pacific (APAC).





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





The
      balance sheet at December 31, 2005 has been derived from the audited financial
      statements at that date but does not include all of the information and
      footnotes required by accounting principles generally accepted in the United
      States of America for complete financial statements.





These
      financial statements should be read in conjunction with our audited consolidated
      financial statements for the year ended December 31, 2005, included in the
      Company’s Form 10-K for the year ended December 31, 2005 as filed with the
      Securities and Exchange Commission. Our results of operations for any interim
      period are not necessarily indicative of the results of operations for any
      other
      interim period or for a full fiscal year.





*Stock
      Based Compensation*




On
      January 1, 2006, the Company adopted the Statement of Financial Accounting
      Standards No. 123 (revised 2004), *Share-Based
      Payment* (FAS
      123R), which requires the measurement and recognition of compensation expense
      for all share-based payment awards made to employees and directors under the
      Company’s stock option plans, based on fair values. FAS 123R supersedes the
      Company’s previous accounting under Accounting Principles Board Opinion No. 25, *Accounting
      for Stock Issued to Employees* (APB
      25). In March 2005, the Securities and Exchange Commission issued Staff
      Accounting Bulletin No. 107 (SAB 107) relating to FAS 123R, which the Company
      utilized in its adoption of FAS 123R beginning January 1, 2006.


5
 Table
          of Contents





The
      Company adopted FAS 123R using the modified prospective transition method,
      which
      requires the application of the accounting standard as of January 1, 2006,
      the
      first day of the Company’s fiscal year. The Company’s Condensed Consolidated
      Financial Statements as of and for the three months ended March 31, 2006 reflect
      the impact of FAS 123R. In accordance with the modified prospective transition
      method, the Company’s Condensed Consolidated Financial Statements for prior
      periods have not been restated to reflect, and do not include, the impact of
      FAS
      123R. Stock-based compensation expense for employee stock options recognized
      under FAS 123R for the three months ended March 31, 2006 was
      $489,000.





FAS
      123R
      requires companies to estimate the fair value of share-based payment awards
      on
      the date of grant using an option-pricing model. The value of the portion of
      the
      award that is ultimately expected to vest is recognized as expense over the
      requisite service periods in the Company’s Statement of Income. Prior to the
      adoption of FAS 123R, the Company accounted for stock-based awards to employees
      and directors using the intrinsic value method in accordance with APB 25 as
      allowed under Financial Accounting Standards No. 123, *Accounting
      for Stock-Based Compensation* (FAS
      123). Under the intrinsic value method, no stock-based compensation expense
      had
      been recognized in the Company’s Consolidated Statement of Income, other than as
      related to stock options for non-employees.





Stock-based
      compensation expense recognized during the period is based on the value of
      the
      portion of share-based payment awards that is ultimately expected to vest during
      the period. Stock-based compensation expense recognized in the Company’s
      Condensed Consolidated Statement of Income for the first quarter of 2006
      included compensation expense for share-based payment awards granted prior
      to,
      but not yet vested as of January 1, 2006, based on the grant date fair value
      estimated in accordance with the pro forma provisions of FAS 123, and
      compensation expense for the share-based payment awards granted subsequent
      to
      January 1, 2006 based on the grant date fair value estimated in accordance
      with
      the provisions of FAS 123R. Compensation expense for all share-based payment
      awards are recognized using the straight-line single option approach.
      Stock-based compensation expense recognized in the Consolidated Condensed
      Statement of Income for the first quarter of 2006 is based on awards ultimately
      expected to vest and has been reduced for estimated forfeitures. FAS 123R
      requires forfeitures to be estimated at the time of grant and revised, if
      necessary, in subsequent periods if actual forfeitures differ from those
      estimates. In the Company’s pro forma disclosure required under FAS 123, for the
      periods prior to 2006, the Company accounted for forfeitures as they
      occurred.





With
      the
      adoption of FAS 123R, the Company continued to use the Black-Scholes
      option-pricing model as its method of valuation for share-based awards. For
      additional information, refer to Note 3. The Company’s determination of fair
      value of share-based payment awards on the date of grant using an option-pricing
      model is affected by the Company’s stock price as well as assumptions regarding
      a number of highly complex and subjective variables. These variables include,
      but are not limited to: the Company’s expected stock price volatility over the
      term of the awards, and actual and projected employee stock option exercise
      behaviors. Option-pricing models were developed for use in estimating the value
      of traded options that have no vesting or hedging restrictions and are fully
      transferable.





**2.**
            **Net
                Income Per Common Share**





Basic
      net
      income per share is calculated based on the weighted-average number of
      outstanding common shares in accordance with Financial Accounting Standards
      No.
      128, *Earnings
      per Share* .
      Diluted
      net income per share is calculated based on the weighted-average number of
      outstanding common shares plus the effect of dilutive potential common shares.
      Potential common shares are composed of shares of common stock issuable upon
      the
      exercise of stock options. The calculation of diluted net income per share
      excludes shares underlying outstanding stock options whose effect would be
      antidilutive.


6
 Table
          of Contents





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





**Three
                Months Ended**
              **March
                31,****2006**
            
            **2005**Net
                income, as reported (A)
            
            $
            1,012
            
            $
            25Weighted
                average outstanding shares of common stock (B)
            
            
            16,251
            
            
            15,958Dilutive
                effect of options to purchase common stock
            
            
            927
            
            
            596Common
                stock and common stock equivalent shares (C)
            
            
            17,178
            
            
            16,554Net
                income per share:Basic
                (A/B)
            
            $
            0.06
            
            $
            0.00Diluted
                (A/C)
            
            
            0.06
            
            
            0.00





The
      Company’s calculation of diluted net income per share for the three months ended
      March 31, 2006 and 2005 excludes options to purchase 1.3 million and 2.4 million
      shares of common stock, respectively, as their effect would be antidilutive.





**3.**  **Stock-Based
      Compensation**





The
      Company's Stock Option Plans, adopted in 1995 and 1999, authorize the Board
      of
      Directors or the Compensation Committee, as applicable, to grant incentive
      and
      nonqualified stock options. Up to an aggregate of 4,050,000 shares are available
      for issuance under the 1999 Stock Option Plans. The exercise price of incentive
      options must not be less than the fair market value of the common stock at
      the
      date of grant. Options granted under the 1999 Stock Option Plan generally vest
      in equal installments over four years from the first anniversary of the date
      of
      grant. For most options granted through December 31, 2004, the term of each
      option is ten years from the date of grant. In 2005, the Company began issuing
      options with a life of six years from the date of grant. If an incentive option
      is granted to an employee who, at the time the option is granted, owns stock
      representing more than ten percent of the voting power of all classes of stock
      of the Company, the
      exercise price of the option may not be less than 110% of the market value
      per
      share on the date the option is granted andthe term of the option shall
      be five years from the date of grant. The plans may be terminated by the Board
      of Directors at any time.





*Pro
      Forma Information under FAS 123 for Periods Prior to 2006*





Prior
      to
      the adoption of FAS 123R, the Company provided the disclosures required under
      FAS 123, as amended by Statement of Financial Accounting Standards No. 148,
      *Accounting for Stock-Based Compensation - Transition and Disclosures*
      and recognized compensation expense for certain non-employee stock options
      that
      were granted. The Company did not recognize stock-based compensation expense
      in
      its Statement of Income for periods prior to the adoption of FAS 123R for
      employee stock option grants as all options granted had an exercise price equal
      to the market value of the underlying common stock on the date of the
      grant.





Pro
      forma
      information regarding option grants made to the Company’s employees and
      directors is as follows (in thousands, except per share amounts):


**Three
                  Months Ended**
                **March
                  31, 2005**Net
                  income as reported
              
              $
              25Add:
                  Stock-based compensation expense for non-employee stock options
                  included
                  in reported net income, net of related tax effects
              
              
              43Deduct:
                  Total stock-based compensation expense determined under fair-value-based
                  method for all awards
              
              
              (789
              )Pro
                  forma net loss
              
              $
              (721
              )Net
                  income (loss) per share:Basic
                  - as reported
              
              $
              0.00Diluted
                  - as reported
              
              
              0.00Basic
                  - pro forma
              
              
              (0.05
              )Diluted
                  - pro forma
              
              
              (0.05
              )




7
 Table
          of Contents




*Valuation
      and Expense Information under FAS 123R*





The
      following table summarizes the allocation of stock-based compensation expense
      related to employee stock options under FAS 123R for the three months ended
      March 31, 2006 (in thousands, except per share amounts):





**Three
                Months Ended**
              **March
                31, 2006**Stock-based
                compensation expense for employee stock options:Cost
                of services
            
            $
            39Sales
                and marketing
            
            
            285Research
                and development
            
            
            49General
                and administrative
            
            
            116Total
                stock-based compensation expense for employee stock
                options
            
            $
            489Basic
                and diluted net income per share - as reported
            
            $
            0.06Effect
                of stock-based compensation for employee stock options on basic and
                diluted earnings per share
            
            
            (0.03
            )





During
      the three months ended March 31, 2006, the Company granted stock options for
      349,000 shares of common stock with an estimated total grant-date fair value
      of
      approximately $1.0 million. As required by FAS 123R, management has made an
      estimate of expected forfeitures and is recognizing compensation costs only
      for
      those stock awards expected to vest. Of the $1.0 million described above, the
      Company estimated that the total stock-based compensation for the awards not
      expected to vest was $229,000.





*Valuation
      Assumptions*





The
      Company estimated the fair value of stock options using the Black-Scholes
      valuation model. The fair value of each option grant is estimated on the date
      of
      grant and is amortized on a straight-line basis over the vesting period. The
      weighted-average estimated value of options granted to employees and directors
      under the stock option plans was $2.97 during the three months ended March
      31,
      2006 and $3.16 during the three months ended March 31, 2005 using the
      Black-Scholes model with the following assumptions:


**Three
                    Months Ended**
                  **March
                    31,****2006**
                
                **2005**Dividend
                    yield
                
                
                --
                
                
                --Expected
                    volatility
                
                
                68.6
                %
                
                78.6
                %Risk-free
                    interest rate
                
                
                4.73
                %
                
                4.25
                %Expected
                    life of option (in years)
                
                
                4.25
                
                
                4.25


*Expected
      Dividend:* The
      Black-Scholes valuation model calls for a single expected dividend yield as
      an
      input. The Company has not issued any dividends and has no expectation to do
      so
      in the foreseeable future.





*Expected
      Volatility* :
      The
      Company’s volatility factor was based exclusively on its historical stock prices
      over the most recent period commensurate with the estimated expected life of
      the
      stock options.





*Risk-Free
      Rate:* The
      Company bases the risk-free interest rate used in the Black-Scholes valuation
      method on the implied yield currently available on U.S. Treasury zero-coupon
      issues with an equivalent remaining term commensurate with the estimated
      expected life of the stock options.


*Expected
        Term* :
        The
        Company’s expected term represents the period that the Company’s stock options
        are expected to be outstanding and was determined using the simplified method
        discussed in SAB 107.
 
 *Estimated
        Pre-vesting Forfeitures:*Beginning
        January 1, 2006, the Company included an estimate for forfeitures in calculating
        stock option expense*.* When
        estimating forfeitures, the Company considers historical termination behavior
        as
        well as any future trends it expects. Prior to 2006, the Company accounted
        for
        forfeitures of employee stock options for pro forma disclosure puposes under
        FAS
        123 on an as-incurred basis.


8
 Table
          of Contents




*Stock
      Option Activity*





The
      following is a summary of options activities for the three months ended March
      31, 2006:





**Options**
            
            **Weighted**
              **Average**
              **Exercise**
              **Price**Balances
                at January 1, 2006
            
            
            3,853,688
            
            $
            5.44Options
                granted
            
            
            349,000
            
            
            5.23Options
                exercised
            
            
            (241,086
            )
            
            3.57Options
                canceled
            
            
            (29,936
            )
            
            4.91Options
                outstanding at March 31, 2006
            
            
            3,931,666
            
            
            5.54Option
                price range at end of period
            
            $
            0.13
                - $50.50Options
                exercisable at end of period
            
            
            2,351,759
            
            $
            5.97Options
                available for grant at end of period
            
            
            368,261Weighted
                average fair value of options granted during the period
            
            $
            2.97





The
      following table summarizes information about the options outstanding at March
      31, 2006:





**Options
                Outstanding**
            
            **Options
                Exercisable****Range
                of Exercise Prices**
            
            **Number**
              **Outstanding**
            
            **Weighted**
              **Average**
              **Remaining**
              **Contractual**
              **Life**
            
            **Weighted**
              **Average**
              **Exercise**
              **Price**
            
            **Number**
              **Exercisable**
            
            **Weighted**
              **Average**
              **Exercise**
              **Price**$
                0.13 - $ 2.99
            
            
            469,649
            
            
            3.52
                years
            
            $
            1.71
            
            
            409,532
            
            $
            1.54$
                3.00 - $ 4.49
            
            
            1,012,822
            
            
            5.90
                years
            
            
            3.63
            
            
            537,779
            
            
            3.39$
                4.50 - $ 5.99
            
            
            1,915,988
            
            
            6.67
                years
            
            
            5.55
            
            
            946,869
            
            
            5.69$
                6.00 - $ 8.99
            
            
            222,548
            
            
            5.61
                years
            
            
            7.24
            
            
            146,920
            
            
            7.79$
                9.00 - $13.49
            
            
            180,420
            
            
            3.77
                years
            
            
            10.72
            
            
            180,420
            
            
            10.72$13.50
                - $50.50
            
            
            130,239
            
            
            4.61
                years
            
            
            23.90
            
            
            130,239
            
            
            23.90Total/average
            
            
            3,931,666
            
            
            
            
            
            5.54
            
            
            2,351,759
            
            
            5.97




The
        total
        intrinsic value of options exercised during the three months ended March
        31,
        2006 was $812,164. The aggregate intrinsic value of options outstanding as
        of
        March 31, 2006 was $19.2 million and the aggregate intrinsic value of options
        currently exercisable as of March 31, 2006 was $11.2 million. The aggregate
        intrinsic value represents the total intrinsic value, based on the Company’s
        closing stock price of $9.90 as of March 31, 2006, which would have been
        received by the option holders had all option holders exercised their options
        as
        of that date. The total number of in-the-money options exercisable as of
        March
        31, 2006 was 2,098,225, with a weighted average exercise price of $4.54.




As
      of
      March 31, 2006, there was $4.3 million of total unrecognized compensation cost
      related to nonvested stock options. These costs are expected to be recognized
      over the weighted average remaining life of 2.0 years.





The
      Company adopted the 2000 Employee Stock Purchase Plan in May 2000. This plan
      was
      modified as of January 1, 2006 to ensure that it is considered non-compensatory
      under FAS 123R. No compensation expense has been recognized related to this
      plan.





**4.**
            **Reclassifications**





Beginning
      in the second quarter of 2005, the Company reclassified, for prior periods,
      certain foreign currency transaction gains and losses, as well as foreign tax
      withholdings, from sales and marketing, and general and administrative expenses,
      to other income (expense). In addition, the Company reclassified certain
      hardware revenues and expenses from services to product. These reclassifications
      had no impact on the Company’s total consolidated results in any period
      presented.





9
 Table
          of Contents


**5.**
              **Concentration
                  of Credit Risk**
 
 One
        reseller had a concentration of 12% of accounts receivable as of March 31,
        2006.
        No resellers or customers had greater than 10% concentration of accounts
        receivable as of December 31, 2005. No resellers or customers had greater
        than
        10% concentration of revenues for the three months ended March 31, 2006 and
        March 31, 2005.


**6.**
            **Contingencies**





From
      time
      to time the Company has received claims from competitors and other technology
      providers claiming that the Company’s technology infringes their proprietary
      rights. One such claim has resulted in a legal proceeding being filed against
      the Company, which is described below. The Company cannot assure you that these
      matters can be resolved amicably without litigation, or that the Company will
      be
      able to enter into licensing arrangements on terms and conditions that would
      not
      have a material adverse effect on its business, financial condition or results
      of operations.





On
      September 30, 2003, Recursion Software, Inc. filed suit in Dallas County Court
      in Dallas, Texas against the Company alleging breach of contract and money
      due
      under claims of quantum meruit and unjust enrichment. Recursion claims that
      the
      Company incorporated Recursion software into one of its products in breach
      of
      the underlying license. On November 3, 2003, the Company had the case removed
      to
      Federal District Court in Dallas, Texas and on January 28, 2004, Recursion
      asserted a copyright infringement claim against the Company, which was expanded
      in scope on September 10, 2004. No dollar amount has been stated in the action.
      On February 27, 2006, the Court denied both parties’ motions for summary
      judgment. The Company believes that it has strong defenses to the claims and
      intends to vigorously defend against the action. The Company believes that
      this
      matter can be resolved without a material adverse effect on its business,
      financial condition or results of operations; however, the Company cannot
      provide assurance as to the outcome.





In
      November 2002, the Company received a notification from the French government
      as
      a result of a tax audit that had been conducted encompassing the years 1998,
      1999, 2000 and 2001. These assessments claim various taxes are owed related
      to
      Value Added Tax (VAT) and corporation taxes in addition to what has previously
      been paid and accrued. As of March 31, 2006, the assessment related to VAT
      was
      approximately $2.8 million and the assessment related to corporation taxes
      was
      approximately $363,000. The Company’s tax counsel has assessed the possibility
      of the Company paying the assessment related to VAT as remote and the assessment
      related to corporation taxes as reasonably possible. The Company has not accrued
      for these amounts. The Company is appealing the assessments, but cannot assure
      you that these matters will be resolved without litigation or that it will
      not
      have to pay some or all of the assessments. The Company has filed for VAT
      refunds of more than $600,000, to which the French government has not yet
      responded. The Company believes that these VAT refunds could be used to offset
      any money owed to the French government in connection with the
      assessments.





From
      time
      to time, the Company is also involved in certain legal proceedings in the
      ordinary course of conducting its business. While the ultimate liability
      pursuant to these actions cannot currently be determined, the Company believes
      these legal proceedings will not have a material adverse effect on its financial
      position or results of operations. Litigation in general, and intellectual
      property litigation in particular, can be expensive and disruptive to normal
      business operations. Moreover, the results of complex legal proceedings are
      difficult to predict.





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





**Forward-Looking
      Information**





Certain
      statements in this Form 10-Q contain "forward-looking" information (as
      defined in Section 27A of the Securities Act of 1933, as amended and
      Section 21E of the Securities Exchange Act of 1934, as amended) that
      involve risks and uncertainties which may cause actual results to differ
      materially from those predicted in the forward-looking statements.
      Forward-looking statements can often be identified by their use of such verbs
      as
      "expects," "anticipates," and "believes" or similar verbs or conjugations of
      such verbs. If any of our assumptions on which the statements are based prove
      incorrect or should unanticipated circumstances arise, our actual results could
      materially differ from those anticipated by such forward-looking statements.
      The
      differences could be caused by a number of factors or combination of factors,
      including, but not limited to, the Risk Factors described in our Securities
      and Exchange Commission filings, including the Form 10-K filing for the
      year ended December 31, 2005.




**Overview**





We
      are a
      leading provider of software applications for contact centers and are leveraging
      that leadership position to provide mission critical VoIP applications to
      enterprises. Our customers are in a wide variety of industry groups such as
      the
      financial services industry which includes insurance companies, banks and credit
      unions, the healthcare industry and others. We are a global software provider
      with a presence in the Americas; Europe, Middle East and Africa (EMEA); and
      Asia/Pacific (APAC).


10
 Table
            of Contents




**Financial
      Highlights**




For
      the
      three months ended March 31, 2006, revenues grew 2% over the previous three
      month period and 23% over the three months ended March 31, 2005. Factors
      that affect revenues in any particular quarter include potential customers’
budget constraints, personnel resources to implement our solutions, and
      willingness to implement a critical telecommunications system. As the table
      below shows, revenues in any particular quarter can greatly fluctuate from
      other
      periods. Because the terms of a contract or prior payment experience with a
      customer or reseller affect revenue recognition, revenue recognition may occur
      in a period later than when an order is received.





The
      information below shows our total revenues (in millions) for the most recent
      five quarters and the years ended December 31, 2005, 2004 and 2003 and the
      percentage change over the previous period.





**Period**
            
            **Revenues**
            
            **%
                Growth**Three
                months ended:March
                31, 2006
            
            $
            17.9
            
            
            2
            %December
                31, 2005
            
            
            17.5
            
            
            15September
                30, 2005
            
            
            15.2
            
            
            (3
            )June
                30, 2005
            
            
            15.6
            
            
            7March
                31, 2005
            
            
            14.6
            
            
            2Year
                ended December 31:2005
            
            $
            62.9
            
            
            14
            %2004
            
            
            55.1
            
            
            72003
            
            
            51.5
            
            
            8





For
      the
      three months ended March 31, 2006, product revenues increased 12% compared
      to
      the three months ended March 31, 2005. Services revenues increased 35% for
      the
      same periods. The large increase in services revenues was related to an increase
      of $2.2 million in support fees due to our growing installed customer base.
      In
      addition, professional services and education revenues increased a total of
      $250,000 in the three months ended March 31, 2006 compared to March 31,
      2005.





Effective
      January 1, 2006, we adopted the Statement of Financial Accounting Standards
      No.
      123 (revised 2004), *Share-Based
      Payment* (FAS
      123R) which requires the measurement and recognition of compensation expense
      for
      all share-based payment awards made to employees under the Company’s stock
      option plans, based on fair values. The adoption of FAS 123R had a significant
      effect on our costs during the three month period ended March 31, 2006. The
      following table summarizes stock-based compensation expense related to employee
      stock options under FAS 123R for the three months ended March 31, 2006 which
      was
      allocated as follows (in thousands, except per share amounts):





**Three
                Months Ended**
              **March
                31, 2006**Stock-based
                compensation expense for employee stock options:Cost
                of services
            
            $
            39Sales
                and marketing
            
            
            285Research
                and development
            
            
            49General
                and administrative
            
            
            116Total
                stock-based compensation expense for employee stock
                options
            
            $
            489Basic
                and diluted net income per share - as reported
            
            $
            0.06Effect
                of stock-based compensation for employee stock options on basic and
                diluted earnings per share
            
            
            (0.03
            )




Operating
      expenses for the three months ended March 31,
      2006 increased $1.4 million compared to the three months ended March 31, 2005.
      Of this increase, $450,000 was due to compensation expense related to FAS
      123R for sales and marketing, research and development and general and
      administrative, as detailed above. In addition, we experienced increases in
      commission expenses, marketing efforts, professional services related to legal
      fees and Sarbanes-Oxley 404 costs and general and administrative staffing
      increases. These increases were slightly offset by decreases in depreciation,
      particularly in research and development, and in outsourced services related
      to
      translating our products into foreign languages.


11
 Table
          of Contents




We
      had
      $18.9 million of cash and cash equivalents and short-term investments as of
      March 31, 2006. Cash and cash equivalents and short-term investments increased
      from $15.1 million as of December 31, 2005 as a result of net earnings for
      the three months ended March 31, 2006 and cash collections of accounts
      receivable.





Based
      on
      currently issued non-vested options, we expect 2006 expenses related to FAS
      123R
      to be approximately $1.7 million, or approximately $480,000 for the three months
      ended June 30, 2006, $380,000 for the three months ended September 30, 2006
      and
      $360,000 for the three months ended December 31, 2006.






**Historical
      Results of Operations**




The
      following table presents certain financial data, derived from our unaudited
      statements of income, as a percentage of total revenues for the periods
      indicated. The operating results for the three months ended March 31, 2006
      and
      2005 are not necessarily indicative of the results that may be expected for
      the
      full year or for any future period.





**Three
                Months Ended**
              **March
                31,****2006**
            
            **2005**Revenues:Product
            
            
            49
            %
            
            54
            %Services
            
            
            51
            
            
            46Total
                revenues
            
            
            100
            
            
            100Cost
                of revenues:Product
            
            
            7
            
            
            5Services
            
            
            18
            
            
            19Total
                cost of revenues
            
            
            25
            
            
            24Gross
                profit
            
            
            75
            
            
            76Operating
                expenses:Sales
                and marketing
            
            
            38
            
            
            40Research
                and development
            
            
            17
            
            
            22General
                and administrative
            
            
            14
            
            
            14Total
                operating expenses
            
            
            69
            
            
            76Operating
                income
            
            
            6
            
            
            --Other
                income:Interest
                income, net
            
            
            --
            
            
            --Other
                income (expense), net
            
            
            --
            
            
            --Total
                other income
            
            
            --
            
            
            --Income
                before income taxes
            
            
            6
            
            
            --Income
                taxes
            
            
            --
            
            
            --Net
                income
            
            
            6
            %
            
            --
            %





**Comparison
      of Three Months Ended March 31, 2006 and 2005**




***Revenues***




*Product
      Revenues*




**Three
                Months Ended**
              **March
                31,****2006**
            
            **2005****($
                in thousands)**Product
                revenues
            
            $
            8,861
            
            $
            7,886Change
                from prior year
            
            
            12
            %
            
            13
            %Percentage
                of total revenues
            
            
            49
            %
            
            54
            %


12
 Table
          of Contents


In
      the
      three months ended March 31, 2006, the total dollar amount of orders increased
      39% over the three months ended March 31, 2005. The recognition of product
      revenues is affected by whether the related contract is perpetual or time-based
      and by the related revenue recognition criteria.





The
      increase in product orders for the three months ended March 31, 2006 compared
      to
      March 31, 2005, was primarily related to an increase in product orders in EMEA.
      We continue to experience increasing revenues in this region due to the efforts
      of our EMEA sales staff, our EMEA partner network and marketing efforts in
      that
      region.





The
      product revenues as a percentage of total revenues decreased in the three months
      ended March 31, 2006 compared to the three months ended March 31, 2005 due
      to
      the increase in our services revenues, as described below.





*Services
      Revenues*




**Three
                Months Ended**
              **March
                31,****2006**
            
            **2005****($
                in thousands)**Services
                revenues
            
            $
            9,069
            
            $
            6,707Change
                from prior year
            
            
            35
            %
            
            --
            %Percentage
                of total revenues
            
            
            51
            %
            
            46
            %





Services
      revenues are principally support and license renewal fees. These revenues also
      include professional services, education and other miscellaneous revenues.
      Our
      services revenues should increase as we continue to sign and implement new
      customers and as existing customers continue to renew annual licenses or support
      agreements for our applications.





For
      the
      three months ended March 31, 2006, support and license renewal fee revenues
      increased $2.2 million over the three months ended March 31, 2005 and
      professional services and education revenues increased a total of $250,000
      over
      the same periods. The
      increase in support and license renewal fee revenues was mainly related to
      our
      growing base of existing customers.




***Cost
      of Revenues***




**Three
                Months Ended**
              **March
                31,****2006**
            
            **2005****($
                in thousands)**Cost
                of revenues:Product
            
            $
            1,333
            
            $
            766Services
            
            
            3,144
            
            
            2,707Total
                cost of revenues
            
            $
            4,477
            
            $
            3,473Change
                from prior year
            
            
            29
            %
            
            4
            %Product
                costs as a % of product revenues
            
            
            15
            %
            
            10
            %Services
                costs as a % of services revenues
            
            
            35
            %
            
            40
            %





Costs
      of
      product consist primarily of product and software royalties paid to third
      parties for the use of their technologies in our products, hardware costs and,
      to a lesser extent, software packaging costs, which include product media,
      duplication and documentation. Costs of product can fluctuate depending on
      which
      software applications are licensed to our customers, the third party technology,
      if any, which is licensed and the dollar amount of systems licensed through
      Vonexus. The increase in the product costs for the three months ended March
      31,
      2006 compared to the three months ended March 31, 2005 was due to Vonexus
      hardware costs and an increase in royalties expensed for third party software
      providers.





Costs
      of
      services consist primarily of compensation expenses for technical support,
      education and professional services personnel and other costs associated with
      supporting our resellers and customers. These costs increased over 16% for
      the
      three months ended March 31, 2006 compared to the three months ended March
      31,
      2005 due to an increase in salary-related expenses as headcount increased by
      20
      total support employees between these two periods. In addition, compensation
      expenses for services related to FAS 123R were $39,000 for the three months
      ended March 31, 2006.


13
 Table
          of Contents


***Gross
      Profit***




**Three
                Months Ended**
              **March
                31,****2006**
            
            **2005****($
                in thousands)**Gross
                profit
            
            $
            13,453
            
            $
            11,120Change
                from prior year
            
            
            21
            %
            
            7
            %Percentage
                of total revenues
            
            
            75
            %
            
            76
            %





The
      increase in the dollar amount of gross profit was primarily the result of an
      increase in revenues, particularly services revenues, partially offset by the
      smaller increase in cost of revenues, both product and services related,
      discussed above.




***Operating
      Expenses***




*Sales
      and Marketing*




**Three
                Months Ended**
              **March
                31,****2006**
            
            **2005****($
                in thousands)**Sales
                and marketing expenses
            
            $
            6,879
            
            $
            5,854Change
                from prior year
            
            
            18
            %
            
            16
            %Percentage
                of total revenues
            
            
            38
            %
            
            40
            %Percentage
                of product revenues
            
            
            78
            %
            
            74
            %





Sales
      and
      marketing expenses are comprised primarily of compensation expenses, promotional
      costs and travel and entertainment expenses. These expenses increased primarily
      due to higher commission expense of over $400,000 related to higher
      commissionable revenues for the three months ended March 31, 2006 compared
      to
      the three months ended March 31, 2005. In addition, overall marketing expenses
      increased $350,000 due to increased marketing efforts. Finally, compensation
      expense for sales and marketing related to FAS 123R was $285,000 for the three
      months ended March 31, 2006.





*Research
      and Development*




**Three
                Months Ended**
              **March
                31,****2006**
            
            **2005****($
                in thousands)**Research
                and development expenses
            
            $
            3,041
            
            $
            3,195Change
                from prior year
            
            
            (5
            )%
            
            (3
            )%Percentage
                of total revenues
            
            
            17
            %
            
            22
            %





Research
      and development expenses are comprised primarily of compensation and
      depreciation expenses. Research and development expenses decreased primarily
      due
      to lower depreciation expense of $135,000 for the three months ended March
      31,
      2006 compared to the three months ended March 31, 2005, as certain of our assets
      become fully depreciated. In addition, outsourced services decreased $85,000
      for
      the three months ended March 31, 2006 compared to the three months ended March
      31, 2005 related to the translation of our products into different languages.
      These decreases were offset by an increase of $49,000 of compensation expense
      related to FAS 123R costs for the three months ended March 31,
      2006.





*General
      and Administrative*




**Three
                Months Ended**
              **March
                31,****2006**
            
            **2005****($
                in thousands)**General
                and administrative expenses
            
            $
            2,534
            
            $
            2,021Change
                from prior year
            
            
            25
            %
            
            8
            %Percentage
                of total revenues
            
            
            14
            %
            
            14
            %


14
 Table
          of Contents


General
      and administrative expenses are comprised of compensation expense and
      non-allocable expenses including bad debt, legal and other professional fees.
      The increase for the three months ended March 31, 2006 compared to the three
      months ended March 31, 2005 was due primarily to an increase in professional
      services of over $100,000 related to increased legal fees and costs related
      to
      Sarbanes-Oxley 404. In addition, general and administrative salaries increased
      over $180,000 for the three months ended March 31, 2006 compared to the three
      months ended March 31, 2005 related to hiring additional employees and
      re-allocating some internal employees. Finally, compensation expense related
      to
      FAS 123R was $116,000 for the three months ended March 31, 2006.




***Other
      Income (Expense)***




*Interest
      Income, net*


Interest
      income, net is primarily comprised of interest earned from investments and
      interest-bearing cash accounts. Interest expense and fees, which are not
      material for any periods reported, is also included in interest income, net.
      Interest earnings improved during the three months ended March 31, 2006 compared
      to the three months ended March 31, 2005 as shown below. Cash earned on
      investments improved partially due to an increasing cash balance. In addition,
      we changed the funds in which we have invested to increase our return on
      investment. The new investments have a higher interest rate and lower
      fees.




**Three
                  Months Ended**
                **March
                  31,****2006**
              
              **2005****($
                  in thousands)**Cash,
                  cash equivalents and short-term investments (average)
              
              $
              16,998
              
              $
              14,879Interest
                  income
              
              
              107
              
              
              52Return
                  on investment
              
              
              2.5
              %
              
              1.4
              %


*Other
      Income (Expense)*


Beginning
      with the three months ended June 30, 2005, we began classifying our foreign
      currency transaction gains and losses, as well as foreign tax withholdings,
      in
      other income (expense) instead of sales and marketing and general and
      administrative expenses. All prior periods have been reclassified to this
      presentation. These amounts depend on the amount of revenue that is generated
      in
      certain international currencies, principally the Euro, and the exchange gain
      or
      loss that results from foreign currency disbursements and receipts.




**Three
                  Months Ended**
                **March
                  31,****2006**
              
              **2005****($
                  in thousands)**Other
                  expense, net
              
              $
              (52
              )
              $
              (46
              )


**Liquidity
      and Capital Resources**




We
      generate cash from the collections we receive related to licensing our
      applications and from annual license renewals, maintenance and support and
      other
      services revenues. We also have in place a $3.0 million line of credit, which
      we
      did not utilize as of March 31, 2006. We use cash primarily for paying our
      employees (including salaries, commissions and benefits), leasing office space,
      paying travel expenses, marketing activities, paying vendors for other services
      and supplies and purchasing property and equipment.





We
      determine liquidity by combining cash and cash equivalents and short-term
      investments net of any outstanding borrowings on our line of credit as shown
      in
      the table below. Our total liquidity position as of March 31, 2006 improved
      compared with our position as of December 31, 2005 due mainly to increased
      net
      income, increasing deferred revenue balances, stock options exercised and strong
      cash collections. We believe that our current liquidity position, when combined
      with our anticipated cash flows from operations, will be sufficient to satisfy
      our operating cash needs over the next 12 months. If cash flows from operations
      are less than anticipated or we have additional cash needs (such as an
      unfavorable outcome in legal proceedings), our liquidity may not be sufficient
      to cover our needs. In this case, we may be forced to raise additional capital,
      either through the capital markets or debt financings. We may not be able to
      receive favorable terms in raising this capital.





**March
                31,**
            
            **December
                31,****2006**
            
            **2005****($
                in thousands)**Cash
                and cash equivalents
            
            $
            14,066
            
            $
            11,551Short-term
                investments
            
            
            4,803
            
            
            3,576Liquidity,
                net
            
            $
            18,869
            
            $
            15,127





15
 Table
          of Contents


Our
      operating activities resulted in net cash provided of $3.3 million and $934,000
      for the three months ended March 31, 2006 and 2005, respectively. This increase
      in net cash provided was primarily a result of increased net income, increasing
      deferred revenue balances and strong cash collections on accounts receivable.





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





We
      purchased property and equipment with a cost of $488,000 and $566,000 in the
      three months ended March 31, 2006 and 2005, respectively. These purchases
      related mainly to in-house technology and leasehold improvements for our
      corporate headquarters.





Net
      cash
      provided by financing activities was $919,000 and $184,000 for the three months
      ended March 31, 2006 and 2005, respectively. The increase in cash provided
      was
      mainly due to proceeds from stock options that were exercised during the period
      as a result of our stock price increasing during the quarter from $5.10 per
      share as of December 31, 2005 to $9.90 per share as of March 31,
      2006.





**Critical
      Accounting Policies and Estimates**




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





***Sources
      of Revenues and Revenue Recognition Polic*** ***y***





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





*Product
      Revenues*




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


·
            persuasive
                evidence of an arrangement exists;


·
            the
                fee is fixed or determinable;


·
            collection
                is probable; and


·
            delivery
                has occurred.





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





For
      a
      perpetual license agreement, upon meeting the revenue recognition criteria
      above, we immediately recognize as product revenues the amount of initial
      license fees if sufficient vendor specific objective evidence of fair value
      exists to support allocating a portion of the total fee to the undelivered
      elements of the arrangement. If sufficient vendor specific objective evidence
      of
      the fair value of the undelivered elements does not exist, we recognize the
      initial license fee as product revenues ratably over the initial term of the
      support agreement. The support period is generally 12 months but may be up
      to 18
      months for initial orders because support begins when the licenses are
      downloaded, when support commences, or no more than six months following the
      contract date.





For
      perpetual license agreements, we recognize revenues related to any hardware
      sales when the revenues related to the corresponding software are
      recognized.


16
 Table
          of Contents





*Services
      Revenues*




Services
      revenues are recognized for annually renewable license agreements and perpetual
      license agreements. For all agreements, the allocation of the initial order
      between product revenues and services revenues is based on the actual renewal
      fee. Under annually renewable license agreements, after the initial license
      period, our customers may renew their license agreement for an additional
      period, typically 12 months, by paying a renewal fee. Under perpetual license
      agreements, we recognize annual support fees as services revenues ratably over
      the post-contract support period, which is typically 12 months.





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




***Allowance
      for Doubtful Accounts Receivable***




We
      record
      bad debt expense based on a percentage of revenue reported each period. We then
      review the allowance for doubtful accounts for each reporting period based
      on a
      detailed analysis of our accounts receivable to determine that the amount of
      the
      allowance for doubtful accounts receivable is appropriately stated at the end
      of
      that period. In the analysis of accounts receivable, we primarily consider
      the
      age of the reseller’s or customer's receivable and also consider the
      creditworthiness of the reseller or customer, the economic conditions of the
      customer's industry, and general economic conditions, among other factors.
      If
      payment is not made timely, we contact the customer or reseller to try to obtain
      payment. If this is not successful, we institute other collection practices
      such
      as generating collection letters, involving our sales representatives and
      ultimately terminating the customer’s or reseller’s access to future upgrades,
      licenses and customer support. Once all collection efforts are exhausted, the
      receivable is written off against the allowance for doubtful
      accounts.




***Research
      and Development***




Through
      March 31, 2006, all research and development expenditures have been expensed
      as
      incurred. Based on our product development process and technological
      feasibility, the date at which capitalization of development costs may begin
      is
      established upon completion of a working model. Costs incurred between
      completion of the working model and the point at which the product is ready
      for
      general release have been insignificant.





**Item
      3. Quantitative and Qualitative Disclosures about Market
      Risk.**





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





We
      manage
      our interest rate risk by maintaining an investment portfolio with debt
      instruments of high credit quality and relatively short average maturities.
      We
      also manage interest rate risk by maintaining sufficient cash and cash
      equivalent balances such that we are typically able to hold our investments
      to
      maturity. We have a line of credit with a variable interest rate based upon
      the
      bank’s prime rate on which we incur interest expense when the line is
      utilized.





**Item
      4. Controls and Procedures.**





We
      maintain a set of disclosure controls and procedures that are designed to ensure
      that information required to be disclosed by us in the reports filed by us
      under
      the Securities Exchange Act of 1934, as amended (Exchange Act) is recorded,
      processed, summarized and reported within the time periods specified in the
      SEC’s rules and forms. We carried out an evaluation, under the supervision and
      with the participation of our management, including our President and Chief
      Executive Officer and our Chief Financial Officer and Treasurer, of the
      effectiveness of the design and operation of our disclosure controls and
      procedures as of March 31, 2006 pursuant to Rule 13a-15(b) of the Exchange
      Act.
      Based on that evaluation, our President and Chief Executive Officer and our
      Chief Financial Officer and Treasurer concluded that our disclosure controls
      and
      procedures were effective.





There
      have been no changes in our internal control over financial reporting that
      occurred during the quarter ended March 31, 2006 that have materially affected,
      or are reasonably likely to materially affect, our internal control over
      financial reporting.




P **ART
        II. OTHER INFORMATION**
 
 **Item
        1. Legal Proceedings.**
  From
        time
        to time we have received claims from competitors and other technology providers
        claiming that our technology infringes their proprietary rights. One such
        claim
        has resulted in a legal proceeding being filed against us, which is described
        below. We cannot assure you that these matters can be resolved amicably without
        litigation, or that we will be able to enter into licensing arrangements
        on
        terms and conditions that would not have a material adverse effect on our
        business, financial condition or results of operations.
 17
 Table
              of
              Contents




On
      September 30, 2003, Recursion Software, Inc. filed suit in Dallas County Court
      in Dallas, Texas against us alleging breach of contract and money due under
      claims of quantum meruit, unjust enrichment and infringement. Recursion claims
      that we incorporated Recursion software into one of our products in breach
      of
      the underlying license. On November 3, 2003, we had the case removed to Federal
      District Court in Dallas, Texas and on January 28, 2004, Recursion asserted
      a
      copyright infringement claim against us, which was expanded in scope on
      September 10, 2004. No dollar amount has been stated in the action. On February
      27, 2006, the Court denied both parties’ motions for summary judgment. We
      believe that we have strong defenses to the claims and intend to vigorously
      defend against the action. We believe that this matter can be resolved without
      a
      material adverse effect on our business, financial condition or results of
      operations; however, we cannot provide assurance as to the outcome.





In
      November 2002, we received a notification from the French government as a result
      of a tax audit that had been conducted encompassing the years 1998, 1999, 2000
      and 2001. These assessments claim various taxes are owed related to Value Added
      Tax (VAT) and corporation taxes in addition to what has previously been paid
      and
      accrued. As of March 31, 2006, the assessment related to VAT was approximately
      $2.8 million and the assessment related to corporation taxes was approximately
      $363,000. Our tax counsel has assessed the possibility of us paying the
      assessment related to VAT as remote and the assessment related to corporation
      taxes as reasonably possible. We have not accrued for these amounts. We are
      appealing the assessments, but cannot assure you that these matters will be
      resolved without litigation or that we will not have to pay some or all of
      the
      assessments. We have filed for VAT refunds of more than $600,000, to which
      the
      French government has not yet responded. We believe that these VAT refunds
      could
      be used to offset any money owed to the French government in connection with
      the
      assessments.





From
      time
      to time, we are also involved in certain intellectual property claims and legal
      proceedings in the ordinary course of conducting our business. While the
      ultimate liability pursuant to these actions cannot currently be determined,
      we
      believe these claims and legal proceedings will not have a material adverse
      effect on our financial position or results of operations. Litigation in
      general, and intellectual property litigation in particular, can be expensive
      and disruptive to normal business operations. Moreover, the results of complex
      legal proceedings are difficult to predict.




**Item
        1A. Risk Factors.**
 
 You
        should carefully consider the risks and uncertainties we describe both in
        this
        Report and in the “Risk Factors” section of our Annual Report on Form 10-K for
        the year ended December 31, 2005 before deciding to invest in, or retain,
        shares
        of our common stock. These are not the only risks and uncertainties that
        we
        face. Additional risks and uncertainties that we do not currently know about,
        we
        currently believe are immaterial or we have not predicted may also harm our
        business operations or adversely affect us. If any of these risks or
        uncertainties actually occurs, our business, financial condition, results
        of
        operations or cash flows could be materially adversely affected.





**Item
      6. Exhibits.**





(a)
            Exhibits





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





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




10.5  Form
        of
        Change of Control and Retention Agreement, dated as of March 13, 2006, by
        and
        between Interactive Intelligence, Inc. and each of Stephen R. Head, Joseph
        A.
        Staples and Pamela J. Hynes (incorporated herein by reference from the same
        exhibit number to Company’s Form 8-K filed on March 17, 2006)


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





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





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





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


18
 Table
          of Contents











**SIGNATURES**





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





Interactive
                Intelligence, Inc.(Registrant)Date:
                May 8, 2006
            By/s/
                Stephen R. HeadStephen
                R. Head*Chief
                Financial Officer, Vice President of Finance and**Administration,
                Secretary and Treasurer**(Principal
                Financial Officer and Principal Accounting
                Officer)*








19