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**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION****Washington, D.C. 20549**

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**FORM10-Q**

**(Mark One)**
| **ý** | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|------------|----------------------------------------------------------------------------------------------|

 

**For the quarterly period endedJune 30, 2001**

**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 Number000-27385**

**INTERACTIVEINTELLIGENCE, INC.******(Exact name ofregistrant as specified in its charter)

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

 

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

                           Yesý   No o

             Thenumber of shares of common stock outstanding on July 31, 2001 was 15,119,009.

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TABLEOF CONTENTS

| PART 1. FINANCIAL  INFORMATION |
|--------------------------------|
|                           |
| Item  1.                       | Condensed  Consolidated Balance Sheets as of June 30, 2001 and December 31, 2000 |
|                           |   |
|                           | Condensed  Consolidated Statements of Operations for the three and six months ended June  30, 2001 and 2000 |
|                           |   |
|                           | Condensed  Consolidated Statements of Cash Flows for the six months ended June 30, 2001  and 2000 |
|                           |   |
|                           | Notes  to Condensed Consolidated Financial Statements |
|                           |   |
| Item  2.                       | Management's  Discussion and Analysis of Financial Condition and Results of Operations |
|                           |   |
| Item  3.                       | Qualitative  and Quantitative Disclosures About Market Risk |
|                           |   |
|                           |   |
| PART II. OTHER INFORMATION     |
|                           |
| Item 1.                        | Legal Proceedings |
|                           |   |
| Item  2.                       | Changes  in Securities and Use of Proceeds |
|                           |   |
| Item  4.                       | Submission  of Matters to a Vote of Security Holders |
|                           |   |
| Item 6.                        | Exhibits and  Reports on Form 8-K |
|                           |   |
|                           | Signature |
|                                |  |  |

 

**PART I.  FINANCIALINFORMATION**

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

** **

**Interactive Intelligence, Inc.**

**Condensed Consolidated BalanceSheets****(in thousands, except share amounts)**

|                                       | **June 30,  2001**                                                                                                                                                  |    | **December 31,  2000** |       |
|--------------------------------------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------|---------|------------------------|------------|
|                                       | ****                                                                                                                                                                |    | ****                   |       |
| **Assets**                                 | **(Unaudited)**                                                                                                                                                     |    |                   | ** ** |
| Current assets:                            |                                                                                                                                                                |    |                   |       |
|                                       | Cash and cash equivalents                                                                                                                                           | $       | 7,889                  |       | $ | 1,999 |   |
|                                       | Short-term investments                                                                                                                                              | 16,196  |                   | 10,710     |   |
|                                       | Accounts receivable, net of  allowance for doubtful accounts accounts of $1,022 in 2001 and $631 in 2000                                                            | 11,181  |                   | 9,478      |   |
|                                       | Prepaid expenses                                                                                                                                                    | 1,395   |                   | 970        |   |
|                                       | Other current assets                                                                                                                                                | 470     |                   | 186        |   |
|                                       |                                                                                                                                                                |         |                   |            |   |
| Total current assets                       | 37,131                                                                                                                                                              |    | 23,343                 |       |
|                                       |                                                                                                                                                                |    |                   |       |
| Property and equipment, net                | 9,779                                                                                                                                                               |    | 8,389                  |       |
|                                       |                                                                                                                                                                |    |                   |       |
| Long-term investments                      | 1,045                                                                                                                                                               |    | 1,012                  |       |
| Other assets, net                          | 1,181                                                                                                                                                               |    | 907                    |       |
|                                       |                                                                                                                                                                     |    |                        |       |
| Total assets                               | $                                                                                                                                                                   | 49,136  |                   | $          | 33,651 |   |
|                                       |                                                                                                                                                                     |    |                        |       |
|                                       |                                                                                                                                                                |    |                   |       |
| **Liabilities and shareholders'  equity**  |                                                                                                                                                                |    |                   |       |
| Current liabilities:                       |                                                                                                                                                                |    |                   |       |
|                                       | Accounts payable and accrued  liabilities                                                                                                                           | $       | 3,369                  |       | $ | 3,920 |   |
|                                       | Accrued compensation and  related expenses                                                                                                                          | 1,889   |                   | 1,128      |   |
|                                       | Deferred revenue                                                                                                                                                    | 11,918  |                   | 7,421      |   |
|                                       | Current portion of capital  lease obligations                                                                                                                       | 122     |                   | 377        |   |
|                                       |                                                                                                                                                                |         |                   |            |   |
| Total current liabilities                  | 17,298                                                                                                                                                              |    | 12,846                 |       |
|                                       |                                                                                                                                                                |    |                   |       |
| 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; 15,062,592 issued and outstanding at June 30, 2001,  14,343,907 issued and outstanding at December 31, 2000 | 151     |                   | 143        |   |
|                                       | Additional paid-in capital                                                                                                                                          | 62,440  |                   | 46,995     |   |
|                                       | Accumulated other  comprehensive income                                                                                                                             | 9       |                   | 38         |   |
|                                       | Accumulated deficit                                                                                                                                                 | (30,762 | )                      | (26,371    | ) |
|                                       |                                                                                                                                                                |         |                   |            |   |
| Total shareholders' equity                 | 31,838                                                                                                                                                              |    | 20,805                 |       |
|                                       |                                                                                                                                                                     |    |                        |       |
| Total liabilities and shareholders' equity | $                                                                                                                                                                   | 49,136  |                   | $          | 33,651 |   |
|                                       |                                                                                                                                                                     |    |                        |       |
|                                       |                                                                                                                                                                |    |                   |       |
| See accompanying notes.                    |                                                                                                                                                                |    |                   |       |

 

**InteractiveIntelligence, Inc.**

**Condensed Consolidated Statementsof Operations****(unaudited)(in thousands, except per share amounts)**

|                                       | **Three months ended  June 30,** |       | **Six months ended  June 30,** |       |
|--------------------------------------------|----------------------------------|------------|--------------------------------|------------|
|                                       | ****                             |       | ****                           |       |
|                                       | **2001**                         |       | **2000**                       |       | **2001** |   | **2000** | ** ** |
|                                       | ****                             |       | ****                           |       | **** |   | **** |   |
| Revenues:                                  |                             |       |                           |       |   |   |   |   |
|                                       | Software                         | $          | 8,379                          |       | $ | 6,279 |   | $ | 17,291 |   | $ | 11,225 |   |
|                                       | Services                         | 4,337      |                           | 2,339      |   | 8,097 |   | 4,433 |   |
|                                       |                                  |       |                                |       |  |   |  |   |
| Total revenues                             | 12,716                           |       | 8,618                          |       | 25,388 |   | 15,658 |   |
|                                       |                             |       |                           |       |   |   |   |   |
| Costs and expenses:                        |                             |       |                           |       |   |   |   |   |
|                                       | Costs of software                | 154        |                           | 134        |   | 303 |   | 197 |   |
|                                       | Costs of services                | 3,695      |                           | 2,290      |   | 7,247 |   | 4,216 |   |
|                                       | Sales and marketing              | 5,867      |                           | 4,340      |   | 11,301 |   | 7,862 |   |
|                                       | Research and development         | 3,936      |                           | 2,563      |   | 7,818 |   | 4,833 |   |
|                                       | General and administrative       | 2,033      |                           | 1,288      |   | 3,636 |   | 2,432 |   |
|                                       |                             |            |                           |            |   |  |   |  |   |
| Total costs and expenses                   | 15,685                           |       | 10,615                         |       | 30,305 |   | 19,540 |   |
|                                       |                                  |       |                                |       |  |   |  |   |
| Operating loss                             | (2,969                           | )          | (1,997                         | )          | (4,917 | ) | (3,882 | ) |
|                                       |                             |       |                           |       |   |   |   |   |
| Interest income (expense), net             | 349                              |       | 293                            |       | 667 |   | 574 |   |
|                                       |                                  |       |                                |       |  |   |  |   |
| Loss before income taxes                   | (2,620                           | )          | (1,704                         | )          | (4,250 | ) | (3,308 | ) |
|                                       |                             |       |                           |       |   |   |   |   |
| Income taxes                               | 81                               |       | 43                             |       | 141 |   | 80 |   |
|                                       |                                  |       |                                |       |  |   |  |   |
|                                       |                             |       |                           |       |   |   |   |   |
| Net loss                                   | $                                | (2,701     | )                              | $          | (1,747 | ) | $ | (4,391 | ) | $ | (3,388 | ) |
|                                       |                                  |       |                                |       |  |   |  |   |
|                                       |                             | ** ** |                           | ** ** |   | ** ** |   | ** ** |
| Net loss per share:                        |                             | ** ** |                           | ** ** |   | ** ** |   | ** ** |
| Basic and diluted                          | $                                | (0.18      | )                              | $          | (0.12 | ) | $ | (0.29 | ) | $ | (0.24 | ) |
|                                       |                                  |       |                                |       |  |   |  |   |
|                                       |                             |       |                           |       |   |   |   |   |
| Shares used to compute net loss per share: |                             |       |                           |       |   |   |   |   |
| Basic and diluted                          | 15,039                           |       | 14,155                         |       | 14,921 |   | 14,043 |   |
|                                       |                             |       |                           |       |   |   |   |   |
|                                       |                             |       |                           |       |   |   |   |   |
| See accompanying notes.                    |                             |       |                           |       |   |   |   |   |
|                                            |                                  |            |                                |            |  |  |  |  |  |  |  |  |  |  |

 

 

| **Interactive Intelligence, Inc.**                                           |
|------------------------------------------------------------------------------|
|                                                                         |   |   |   |   |
| **Condensed Consolidated  Statements of Cash Flows****(unaudited)**          |
| **(in thousands)**                                                           |
|                                                                         |   |   |   |   |
|                                                                         | **Six months ended  June 30,** | ** ** |
|                                                                         | **** | ** ** |
|                                                                         | **2001** |   | **2000** | ** ** |
|                                                                         | **** |   | **** |   |
|                                                                         |   |   |   |   |
| **Operating activities**                                                     |   |   |   |   |
| Net loss                                                                     | $ | (4,391 | ) | $ | (3,388 | ) |
| Adjustments to reconcile net loss to net cash used by operating  activities: |   |   |   |   |
|                                                                         | Depreciation | 1,962 |   | 1,220 |   |
|                                                                         | Amortization of deferred  stock-based compensation | 38 |   | 42 |   |
|                                                                         | Changes in operating assets  and liabilities: |   |   |   |   |
|                                                                         | Accounts receivable | (1,703 | ) | (1,691 | ) |
|                                                                         | Prepaid expenses | (425 | ) | (56 | ) |
|                                                                         | Other current assets | (284 | ) | 12 |   |
|                                                                         | Accounts payable and accrued  liabilities | (551 | ) | 882 |   |
|                                                                         | Accrued compensation and  related expenses | 761 |   | (71 | ) |
|                                                                         | Deferred revenue | 4,497 |   | 1,376 |   |
|                                                                         |   |  |   |  |   |
| Net cash used by operating activities                                        | (96 | ) | (1,674 | ) |
|                                                                         |   |   |   |   |
| **Investing activities**                                                     |   |   |   |   |
| Purchases of property and equipment, net                                     | (3,352 | ) | (3,279 | ) |
| Purchases of available-for-sale investments                                  | (10,225 | ) | (2,190 | ) |
| Sales of available-for-sale investments                                      | 4,677 |   | 6,964 |   |
| Change in other assets                                                       | (274 | ) | (183 | ) |
|                                                                         |  |   |  |   |
| Net cash provided (used) by investing activities                             | (9,174 | ) | 1,312 |   |
|                                                                         |   |   |   |   |
| **Financing activities**                                                     |   |   |   |   |
| Principal payments on capital lease obligations                              | (255 | ) | (310 | ) |
| Proceeds from issuances of common stock                                      | 15,147 |   | - |   |
| Proceeds from stock options exercised                                        | 268 |   | 472 |   |
|                                                                         |  |   |  |   |
| Net cash provided by financing activities                                    | 15,160 |   | 162 |   |
|                                                                         |  |   |  |   |
|                                                                         |   |   |   |   |
| Net increase (decrease) in cash and cash equivalents                         | 5,890 |   | (200 | ) |
|                                                                         |   |   |   |   |
| Cash and cash equivalents, beginning of period                               | 1,999 |   | 2,235 |   |
|                                                                         |  |   |  |   |
| Cash and cash equivalents, end of period                                     | $ | 7,889 |   | $ | 2,035 |   |
|                                                                         |  |   |  |   |
|                                                                         |   |   |   |   |
| See accompanying notes.                                                      |   |   |   |   |
|                                                                              |  |  |  |  |  |  |  |  |

 

Interactive Intelligence, IncNotes to  Condensed Consolidated Financial Statements(Unaudited)

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

InteractiveIntelligence, Inc. (“I3” or the “Company”) is a leading provider of softwarethat manages a broad range of customer interactions including traditionaltelephone calls and faxes as well as Internet-based interactions such ase-mail, text chat, Web callback requests, and voice over Net calls.  The Company’s products provide a completecommunications solution including PBX (private branch exchange), ACD (automatedcall distributor), IVR (interactive voice response), unified messaging, andInternet functionality.   The Companycurrently derives substantially all of its revenues from licenses of itsInteraction Center Platformäproducts and related services.

Principaloperations of the Company commenced during 1997.  In 1998, the Company established a wholly-owned subsidiary inFrance and a branch office in Japan.  In1999, the Company established branch offices in Korea, the United Kingdom, andthe Netherlands.    In 2000, the Companyestablished a wholly-owned subsidiary in Australia.  The Company’s products are marketed in North America, CentralAmerica, South America, Europe, the Asia/Pacific region, Australia, and SouthAfrica.

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

Thebalance sheet at December 31, 2000 has been derived from the audited financialstatements at that date but does not include all of the information andfootnotes required by generally accepted accounting principles for completefinancial statements.

Thesefinancial statements should be read in conjunction with our auditedconsolidated financial statements for the year ended December 31, 2000,included in the Company’s Form 10-K for the year ended December 31, 2000, filedwith the Securities and Exchange Commission on March 30, 2001.  Our results of operations for any interimperiod are not necessarily indicative of the results of operations for anyother interim period or for a full fiscal year.

**2.**          **Net Loss Per Common Share**

Basicloss per share is calculated based on the weighted-average number ofoutstanding common shares.  Diluted lossper share is calculated based on the weighted-average number of outstandingcommon shares plus the effect of dilutive potential common shares.

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

 

|                                                   | Three  Months Ended  June 30, |   | Six  Months Ended  June 30, |   |
|--------------------------------------------------------|-------------------------------|--------|-----------------------------|--------|
|                                                   |                               |   |                             |   |
|                                                   | 2001                          |   | 2000                        |   | 2001 |   | 2000 |   |
|                                                   |                               |   |                             |   |  |   |  |   |
|                                                   |                          |   |                        |   |   |   |   |   |
| Net Loss                                               | $                             | (2,701 | )                           | $      | (1,747 | ) | $ | (4,391 | ) | $ | (3,388 | ) |
|                                                   |                               |   |                             |   |  |   |  |   |
|                                                   |                          |   |                        |   |   |   |   |   |
| Basic and diluted:                                     |                          |   |                        |   |   |   |   |   |
| Weighted-average  shares to compute net loss per share | 15,039                        |   | 14,155                      |   | 14,921 |   | 14,043 |   |
|                                                   |                               |   |                             |   |  |   |  |   |
|                                                   |                          |   |                        |   |   |   |   |   |
| Basic and diluted net  loss per common share           | $                             | (0.18  | )                           | $      | (0.12 | ) | $ | (0.29 | ) | $ | (0.24 | ) |
|                                                   |                               |   |                             |   |  |   |  |   |

 

TheCompany’s calculation of diluted net loss per share excludes potential commonshares as the effect would be antidilutive. Potential common shares are composed of shares of common stock of theCompany issuable on the exercise of stock options.  Options to purchase 2,558,774 shares of common stock withexercise prices of $0.13 to $50.50 per share were outstanding as of June 30,2001 and options to purchase 2,167,639 shares of common stock with exerciseprices of $0.13 to $50.50 per share were outstanding as of June 30, 2000.

During the second quarter of 2001, theCompany offered a limited non-compulsory exchange of outstanding employee stockoptions for new options to be granted under the Interactive Intelligence, Inc.1999 Stock Option and Incentive Plan. The exchange resulted in the voluntary cancellation of options topurchase approximately 218,000 shares of common stock with varying exerciseprices ranging from $12.00 to $49.00 per share.  The new options for those exchanged will be granted at the fairmarket value of the common stock on November 26, 2001.

**3.**          **Bank Line of Credit**

TheCompany currently has an unsecured line of credit with a bank in the amount of$5,000,000 which bears interest at the bank’s prime rate (6.75% at June 30,2001).  As of June 30, 2001, the Companyhad no outstanding balance under the line of credit.  This line of credit expires April 29, 2002.

**4.**          **Shareholders’ Equity**

OnJanuary 25, 2001 we received an equity investment from Cisco Systems, Inc.  We sold 515,517 shares of common stock at aprice of $29.00 per share, yielding approximately $15 million in cash.

**5.**          **Contingencies**

InJune 1999 and September 1999, the Company received letters from a competitor inthe call center market claiming that the Company's products utilizetechnologies 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 be able to enter into a licensingarrangement on terms and conditions that would not have a material adverseeffect on the Company's business, financial condition or results of operations.

InJune 2000 and July 2000 the Company received letters from two other competitorsin the call center market claiming that the Company's products utilizetechnologies pioneered and patented by those competitors.  Although the Company's patent counsel hasnot determined the validity of these patents, the Company is discussing thepossible licensing of certain technologies with these competitors.  The Company cannot assure you that theseclaims can be resolved amicably without litigation, or that it will be able toenter into licensing arrangements on terms and conditions that would not have amaterial adverse effect on the Company's business, financial condition orresults of operations.

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

*Forward-Looking Information*

             Certainstatements in this Form 10-Q contain "forward-looking" information(as defined in Section 27A of the Securities Act of 1933, as amended) thatinvolve 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, 2000.

*Overview*

             Wecommenced operations in October 1994. Through the end of 1996, we focusedprimarily on research and development activities. Our first product wasreleased in March 1997. In 1997 and 1998, we expanded our operations tocapitalize on the increased market demand for communications and interactionmanagement software. We decided, at the expense of profitability, to continueinvesting significantly in research and development, and to accelerate our investmentsin marketing, services and sales operations. We had no revenue in 1996, and ourtotal revenues were $1.6 million in 1997, $9.0 million in 1998,  $19.1 million in 1999 and $38.6 million in2000.  Through the six months ended June30, 2001, our total revenues were $25.4 million.

             Webelieve our investments in research and development and in marketing, servicesand sales operations will continue to be critical to our revenue growth.However, these investments have also significantly increased our operatingcosts and expenses, contributing to the net losses and operating losses that wehave incurred in each fiscal quarter since our formation. We anticipate thatour operating costs and expenses will increase substantially for theforeseeable future as we continue to expand our research and development,marketing, services and sales operations. Accordingly, we are likely tocontinue to experience losses and negative cash flows from operations in futurequarters. We cannot assure you when or if we will achieve profitability or, ifachieved, that we will be able to sustain profitability. Our operating resultshave varied significantly from quarter to quarter and may continue to do so inthe future. 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.

             OnJuly 6, 2001 we commenced a restructuring program to reduce expenses andimprove efficiency due to macro-economic and capital spending issues affectingour industry.  This program included aworldwide workforce reduction, possible consolidation of excess facilities, andpossible restructuring of certain business agreements, functions, andrelationships.  The restructuring programresulted in the reduction of approximately ten percent of the worldwideworkforce.  This reduction affected mostbusiness functions and geographic regions. The restructuring is expected to be completed by the end of the thirdquarter of fiscal 2001.  The financialimpact of the restructuring and other special charges will be presented in thethird quarter of fiscal 2001.

*Historical Results of Operations*

             Thefollowing table presents certain financial data, derived from our unauditedstatements of operations, as a percentage of total revenues for the periodsindicated.  The operating results forthe three and six months ended June 30, 2001 and 2000 are not necessarilyindicative of the results that may be expected for the full year or for anyfuture period.

|                            | **Three  months ended June 30,** |   | **Six  months ended June 30,** |       |
|---------------------------------|----------------------------------|--------|--------------------------------|------------|
|                            | ****                             |   | ****                           |       |
|                            | **2001**                         |   | **2000**                       | ** ** | **2001** |   | **2000** | ** ** |
|                            | ****                             |   | ****                           |       | **** |   | **** |   |
| Revenues:                       |                             |   |                           |       |   |   |   |   |
|                            | Software                         | 66     | %                              | 73         | % | 68 | % | 72 | % |
|                            | Services                         | 34     |                           | 27         |   | 32 |   | 28 |   |
|                            |                             |        |                           |            |   |  |   |  |   |
| Total revenues                  | 100                              |   | 100                            |       | 100 |   | 100 |   |
|                            |                                  |   |                                |       |  |   |  |   |
|                            |                             |   |                           |       |   |   |   |   |
| Costs and expenses:             |                             |   |                           |       |   |   |   |   |
|                            | Costs of software                | 1      |                           | 2          |   | 1 |   | 1 |   |
|                            | Costs of services                | 29     |                           | 26         |   | 29 |   | 27 |   |
|                            | Sales and marketing              | 46     |                           | 50         |   | 44 |   | 50 |   |
|                            | Research and  development        | 31     |                           | 30         |   | 31 |   | 31 |   |
|                            | General and  administrative      | 16     |                           | 15         |   | 14 |   | 16 |   |
|                            |                                  |   |                                |       |  |   |  |   |
| Total costs and  expenses       | 123                              |   | 123                            |       | 119 |   | 125 |   |
|                            |                                  |   |                                |       |  |   |  |   |
|                            |                             |   |                           |       |   |   |   |   |
| Operating loss                  | (23                              | )      | (23                            | )          | (19 | ) | (25 | ) |
| Interest income  (expense), net | 3                                |   | 3                              |       | 3 |   | 4 |   |
|                            |                                  |   |                                |       |  |   |  |   |
| Loss before income  taxes       | (20                              | )      | (20                            | )          | (16 | ) | (21 | ) |
| Income taxes                    | 1                                |   | 0                              |       | 1 |   | 1 |   |
|                            |                                  |   |                                |       |  |   |  |   |
| Net loss                        | (21                              | %)     | (20                            | %)         | (17 | %) | (22 | %) |
|                            |                                  |   |                                |       |  |   |  |   |

 

*Revenues*

             Ourtotal revenues increased 48% from $8.6 million for the three months ended June30, 2000 to $12.7 million for the three months ended June 30, 2001.  Total revenues increased 62% from $15.7million for the six months ended June 30, 2000, to $25.4 million for the sixmonths ended June 30, 2001.  Non-NorthAmerican revenues grew from  $1.5million and $3.5 million for the three and six months ended June 30, 2000respectively, to $2.3 million and $6.0 million for the three and six monthsended June 30, 2001, respectively.  Ourrevenues are derived primarily from license fees and charges for services,including product maintenance, education services, and professionalservices.  The increase in totalrevenues resulted primarily from increases in the number of both new andexisting software licenses and, to a lesser extent, product maintenancerevenues.   We believe that thepercentage increases in revenues achieved in prior periods should not beanticipated in future periods.  Weanticipate that software revenues will continue to represent the majority ofour revenues for the foreseeable future.

*Software.*  Our software revenues increased 33% from $6.3million for the three months ended June 30, 2000, to $8.4 million for the threemonths ended June 30, 2001.  Softwarerevenues increased 54% from $11.2 million for the six months ended June 30,2000, to $17.3 million for the six months ended June 30, 2001.  The increase in software revenues resultedfrom increased market penetration for our products, increased production fromour worldwide reseller channel, and increased direct end-user transactions inNorth America.

*Services.*  Services revenues increased 85% from $2.3million for the three months ended June 30, 2000, to $4.3 million for the threemonths ended June 30, 2001.  Servicesrevenues increased 83% from $4.4 million for the six months ended June 30,2000, to $8.1 million for the six months ended June 30, 2001.  The increase in services revenue wasprimarily due to an increase in product maintenance revenues, which is relatedto our growing installed base of end-user customers.  We also realized education revenues and implementation andcustomization revenues from our professional services organization.

*Cost and Expenses*

              Our total costs and expenses increased 48%from $10.6 million for the three months ended June 30, 2000, to $15.7 millionfor the three months ended June 30, 2001. Total costs and expenses increased 55% from $19.5 million for the sixmonths ended June 30, 2000, to $30.3 million for the six months ended June 30,2001.  The increase in amount wasprimarily due to increases in investments in our research and development,sales and marketing, and services efforts.

*Costs of 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 $134,000 for the three months endedJune 30, 2000, to $154,000 for the three months ended June 30, 2001. Thisrepresents 2% of software revenues in both periods.  Costs of software increased from $197,000 for the six monthsended June 30, 2000 to $303,000 for the six months ended June 30, 2001.  This also represents 2% of software revenuesin both periods.  The dollar increaseswere primarily due to royalties owed as a result of higher software revenuesassociated with our Interaction Center PlatformTM and other relatedproducts.  We expect product royaltiesto continue to increase as we release additional products, release additionalversions of our existing products, and integrate additional third-partyfunctions and features into our product offerings.

*Costs of 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 servicesincreased from $2.3 million for the three months ended June 30, 2000, to $3.7million for the three months ended June 30, 2001.  Costs of services increased from $4.2 million for the six monthsended June 30, 2000, to $7.2 million for the six months ended June 30,2001.  As a percentage of servicesrevenues, cost of services decreased from 98% to 85% for the three months endedJune 30, 2000 and 2001, respectively, and decreased from 95% to 90% for the sixmonths ended June 30, 2000 and 2001, respectively. The increase in amount wasdue to an ongoing effort to maximize our reseller effectiveness and end-usercustomer satisfaction through the development and expansion of our technicalsupport, education and professional services organizations.  We expect that costs of services willincrease as we make continued investments to support our end-user customer baseand resellers.

*Sales and 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 increased from $4.3 million for the three months ended June 30, 2000, to$5.9 million for the three months ended June 30, 2001.  Sales and marketing expenses increased from$7.9 million for the six months ended June 30, 2000 to $11.3 million for thesix months ended June 30, 2001.  Thedollar increases reflect the expansion of our worldwide sales and marketingorganizations, higher sales compensation expenses associated with highersoftware revenues, and increases in worldwide marketing activities such asmarketing communication efforts, trade shows and advertising.  We currently plan to continue investingsignificantly in sales and marketing efforts.

*Research and Development.*  Research and development expenses consistprimarily of compensation expenses for our developers and third party effortsto develop and enhance our products, including adapting our products forspecific non-English languages and allowing our products to effectively runwith alternative hardware configurations. Research and development expenses increased from $2.6 million for thethree months ended June 30, 2000, to $3.9 million for the three months endedJune 30, 2001.   Research anddevelopment expenses increased from $4.8 million for the six months ended June30, 2000, to $7.8 million for the six months ended June 30, 2001.  Currently, all costs related to research anddevelopment of our products are charged to research and development expense asincurred.  The dollar increases inresearch and development expenses were due to the hiring of software developersand third party efforts required to enhance our existing products, investigate,design and develop new products, and localize our products into otherlanguages, including French, German, Italian, Japanese, Korean, Portuguese,Spanish, and Taiwanese.  We believe thata significant investment in research and development has been, and willcontinue to be, critical to market acceptance and additional market penetrationof our products.

*General and Administrative.*  General and administrative expenses consistprimarily of compensation for our administrative, financial, and informationtechnology personnel, and a number of non-allocable costs, including bad debt,legal and other professional service fees. General and administrative expenses increased from $1.3 million for thethree months ended June 30, 2000, to $2.0 million for the three months endedJune 30, 2001.  General andadministrative expenses increased from $2.4 million for the six months endedJune 30, 2000 to $3.6 million for the six months ended June 30, 2001.  The dollar increases were primarily due tothe addition of administrative personnel necessary to support our growingoperations and an increased amount of bad debt expense. We believe our generaland administrative expenses will continue to increase as we expand ouradministrative infrastructure and incur legal and other professional servicefees.

*Interest income, net*

             Interestincome, net is generated primarily from invested funds from our initial publicoffering completed in September 1999 and the equity investment made by CiscoSystems, Inc. (“Cisco”) on January 25, 2001. Net interest income increased from $293,000 for the three months endedJune 30, 2000 to $349,000 for the three months ended June 30, 2001.  Net interest income increased from $574,000for the six months ended June 30, 2000 to $667,000 for the six months endedJune 30, 2001.  This increase can beattributed to the interest earned on the funds provided by the equityinvestment made by Cisco, partially offset by lower effective interest rates.

*Income taxes*

             ForU.S. corporate income tax purposes, we did not recognize a tax benefit relatedto U.S. federal or state income taxes during the three months or six monthsended June 30, 2000 or June 30, 2001 because of the uncertainty of eventuallyrealizing these benefits.  However, wedid recognize a tax expense related to our international operations of $81,000for the three months ended June 30, 2001, and $141,000 for the six months endedJune 30, 2001.

*Liquidity and Capital Resources*

             Asof  June 30, 2001, we had cash and cashequivalents of $7.9 million, $16.2 million in short term investments, a workingcapital balance of $19.8 million, and $1.0 million in long-term investments.

             InSeptember 1999, we sold 3.0 million shares of common stock in our initialpublic offering, generating $39.0 million in cash, before offering expenses.Prior to our initial public offering, we funded our operations primarilythrough equity and debt infusions from our principal stockholder, Dr. Brown,and a $5.0 million equity investment by Dialogic Investment Corporation (nowowned by Intel Corporation), and borrowings under commercial lines of credit.

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

             Ouroperating activities resulted in net cash outflows of $1.7 million for the sixmonths ended June 30, 2000 and $96,000 for the six months ended June 30,2001.  The net operating cash outflowfor the first six months of 2000 was primarily the result of our operating lossand an increase in accounts receivable, partially offset by an increase indeferred revenue and the non-cash depreciation amount.  The net operating cash outflow for the firstsix months of 2001 was primarily due to the operating loss and increase inaccounts receivable, almost entirely offset by an increase in deferred revenueand the non-cash depreciation amount.

             Ourinvesting activities have consisted primarily of capital expenditures for propertyand equipment and purchases and sales of investments.  Our activities resulted in a $1.3 million inflow for the sixmonth period ended June 30, 2000 and a $9.2 million outflow for the six monthperiod ending June 30, 2001.  Theoutflow for the six months ended June 30, 2001 was attributed to net purchasesof available-for-sale investments and capital expenditures for property andequipment.  At June 30, 2001, we did nothave any material commitments for future capital expenditures.

             Forthe six months ended June 30, 2000 we generated $162,000 in net proceeds fromfinancing activities which included stock options exercised partially offset byscheduled repayments of our capital lease lines. For the six months endedJune 30, 2001 we generated $15.1 million in net proceeds from financingactivities which was primarily attributable to the shares issued in connection with the Cisco equityinvestment.  At June 30, 2001, we had noamounts outstanding on our line of credit and were in compliance with all relatedcovenants and restrictions.  This lineof credit is currently scheduled to expire on April 19, 2002.

             Webelieve that our existing cash and cash equivalents and short-term investmentswill be sufficient to meet our working capital and capital expenditurerequirements for at least the next 12 months. After that time, we may requireadditional funds to support our working capital requirements or for othercorporate purposes, and we may seek to raise additional funds through public orprivate equity or debt financings or from other sources. We cannot assure youthat additional financing will be available at all or that, if available, willbe on terms favorable to us or that any additional financing will not diluteyour ownership interest in Interactive Intelligence.

*Factors affecting Operating Results*

**OUR LIMITED OPERATING HISTORY MAKES FINANCIAL FORECASTINGDIFFICULT AND, IN****ASSESSING OUR PROSPECTS, YOU SHOULDCONSIDER OUR EARLY STAGE OF DEVELOPMENT AND****PRESENCE IN A NEW AND RAPIDLY EVOLVINGINDUSTRY**

             Ourlimited operating history makes it difficult to forecast our future operatingresults. We commenced operations in October 1994, but did not begin shipping anInteraction Center Platformä-basedproduct until 1997.  In 1999, we beganshipping Interaction Recorderâ,Interaction DialerTM, and e-FAQTM. Accordingly, you should assess our prospectsin light of the risks and difficulties frequently encountered by companies inthe early stage of development, particularly companies in new and rapidlyevolving industries.

**WE HAVE HISTORICALLY INCURRED LOSSES AND WE MAY NOT ACHIEVEPROFITABILITY**

             Wehave not operated profitably to date. In addition to our loss of  $4.4 million for the six months ended June30, 2001, we incurred net losses of $4.6 million, $7.1 million, and $7.4million in 2000, 1999, and 1998, respectively. At June 30, 2001, we hadaccumulated losses since inception of $30.8 million. We intend to continue tomake significant investments in our research and development, marketing,services and sales operations. We anticipate that these expenses couldsignificantly precede any revenues generated by the increased spending. As aresult, we are likely to continue to experience losses and negative cash flowfrom operations in future quarters. If we do become profitable, we may notsustain or increase our profitability.

**OUR QUARTERLY OPERATING RESULTS HAVE VARIED SIGNIFICANTLYAND, IF SEVERAL****FACTORS AFFECTING OUR BUSINESS CAUSETHEM TO CONTINUE TO DO SO, THE MARKET PRICE OF OUR COMMON STOCK COULD BEAFFECTED**

             Ouroperating results have varied significantly from quarter to quarter and maycontinue to do so in the future depending on a number of factors affecting usor our industry, including many that are beyond our control. 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. In addition, our operating results in a future quarter orquarters may fall below expectations of securities analysts or investors and,as a result, the price of our common stock may fluctuate.

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

             Becauseof our early stage of development and limited number of products, changes in pricingpolicies and the timing of the development, announcement and sale of new orupgraded versions of our products are some of the additional factors that couldcause our revenues and operating results to vary significantly from quarter toquarter.

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

             Wehave generally experienced a lengthy product sales cycle, averagingapproximately six to nine months. The lengthy sales cycle is one of the factorsthat has caused, and may in the future continue to cause, our software revenuesand operating results to vary significantly from quarter to quarter, whichcould affect the market price of our common stock. It also makes it difficultfor us to forecast product license revenues. Because of the uniquecharacteristics of our products, our prospective end-user customers' decisionsto license our products often require significant investment and executivelevel decision making. We believe that many companies currently are not awareof the benefits of interaction management software of the type we license or ofour products and capabilities. For this reason, we must provide a significantlevel of education to prospective end-user customers about the use and benefitsof our products, which can cause potential end-user customers to take manymonths to make these decisions. As a result, sales cycles for end-user customerorders vary substantially from customer to customer. Excessive delay in productsales could materially adversely affect our business, financial condition orresults of operations.             The length of the sales cyclefor end-user customer orders depends on a number of other factors over which wehave 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.

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

**OUR INABILITY TO MANAGE SUCCESSFULLY OUR GROWTH OR OURINCREASINGLY COMPLEX****THIRD PARTY RELATIONSHIPS COULDADVERSELY AFFECT US**

             Ifwe are not able to manage our growth successfully, we will not grow as plannedand our business could be adversely affected. We have grown total revenues to$38.6 million in 2000 from $1.6 million in 1997, and we intend to continue togrow our business operations significantly in the future. Our existingmanagement, operational, financial and human resources and managementinformation systems and controls may be inadequate to support our futureoperations. In addition, 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 more complicated,and we expect this trend to continue in the future. As a result, our inabilityto successfully manage these relationships or negotiate sufficient contractualterms could have a material adverse effect on us.

**WE FACE COMPETITIVE PRESSURES, WHICH MAY HAVE A MATERIALADVERSE EFFECT ON US**

             Themarket for our software products is highly competitive and, because there arerelatively low barriers to entry in the software market, we expect competitionto increase significantly in the future. In addition, because our industry isnew and evolving and characterized by rapid technological change, it isdifficult for us to predict whether, when and by whom new competingtechnologies or new competitors may be introduced into our markets. Currently,our competition comes from several different market segments, includingcomputer telephony platform developers, computer telephony applicationssoftware developers and telecommunications equipment vendors. We cannot assureyou that we will be able to compete effectively against current and futurecompetitors. In addition, increased competition or other competitive pressuresmay result in price reductions, reduced margins or loss of market share, any ofwhich could have a material adverse effect on our business, financial conditionor results of operations.

             Manyof our current and potential competitors have longer operating histories,significantly greater financial, technical, marketing, customer service andother resources, greater name recognition and a larger installed base ofcustomers than we do. As a result, these competitors may be able to respond tonew or emerging technologies and changes in customer requirements faster andmore effectively than we can, or to devote greater resources to thedevelopment, promotion and sale of products than we can. Current and potentialcompetitors have established, and may in the future establish, cooperativerelationships among themselves or with third parties, including mergers oracquisitions, to increase the ability of their products to address the needs ofour current or prospective end-user customers. If these competitors were toacquire significant market share, it could have a material adverse effect onour business, financial condition or results of operations.

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

             Ourability to achieve revenue growth in the future will depend in part on oursuccess in maintaining successful relationships with our existing and futureresellers and OEM partners and in recruiting and training additional resellersand OEM partners. We rely primarily on resellers to market and support our products,and plan on relying more on our OEM partners in the future. We are stilldeveloping and refining our reseller and OEM distribution networks and may beunable to attract additional resellers with both voice and data expertise orappropriate OEM partners that will be able to market our products effectivelyand that will be qualified to provide timely and cost-effective customersupport and service. We generally do not have long-term or exclusive agreementswith our resellers or OEM partners, and the loss of specific larger resellersor OEM partners or a significant number of resellers or OEM partners couldmaterially adversely affect our business, financial condition or results ofoperations.

**OUR MARKETS ARE CHARACTERIZED BY RAPID TECHNOLOGICAL CHANGEWHICH MAY CAUSE US****TO INCUR SIGNIFICANT DEVELOPMENT COSTSAND PREVENT US FROM ATTRACTING NEW****CUSTOMERS**

             Themarket for our products is characterized by rapid technological change,frequent new product introductions and enhancements, uncertain product life cyclesand changing end-user customer demands. The introduction of products embodyingnew technologies and the emergence of new industry standards could renderexisting products obsolete or unmarketable and cause us to incur significantdevelopment costs.

**THE GROWTH OF OUR BUSINESS MAYBE IMPEDED WITHOUT INCREASED USE OF THE INTERNET**

             Theuse of the Internet as a commercial marketplace is at an early stage ofdevelopment. Demand and market acceptance for recently introduced products andservices available over the Internet are still uncertain. In addition,governmental regulation of the Internet, such as imposing sales and othertaxes, access charges, and pricing controls and inhibiting cross–bordercommerce, may reduce the use of the Internet by businesses for their electroniccommerce and customer service needs. To date, governmental regulations have notmaterially restricted commercial use of the Internet. However, the legal andregulatory environment that pertains to the Internet is uncertain and may change.New regulations could reduce the use of the Internet by our end–usercustomers and, in turn, their customers. The lack of acceptance of the Internetas a forum for conducting business could reduce growth in demand for ourproducts and limit the growth of our revenue.
**OUR BUSINESS WILL BE ADVERSELY AFFECTED IF WEB–BASEDELECTRONIC BUSINESS SOLUTIONS ARE NOT WIDELY ADOPTED**

             Ourproducts address a new and emerging market for Web–based, interactiveelectronic business solutions. Therefore, our future success depends on thewidespread adoption of the Web as a primary medium for commerce and businessapplications. The failure of this market to develop, or a delay in thedevelopment of this market, could have a material adverse effect on ourbusiness, financial condition or results of operations. The Web hasexperienced, and is expected to continue to experience, significant user andtraffic growth, which has, at times, caused user frustration with slow accessand download times. The Web infrastructure may not be able to support thedemands placed on it by the continued growth on which our success depends.Moreover, critical issues concerning the commercial use of the Web, such assecurity, reliability, cost, accessibility and quality of service, remainunresolved and may negatively affect the growth of Web use or theattractiveness of commerce and business communication over the Web. Inaddition, the Web could lose its viability due to delays in the development oradoption of new standards and protocols to handle increased activity or due toincreased government regulation and taxation of Internet commerce.

**A DECLINE IN MARKET ACCEPTANCE FOR MICROSOFT CORPORATIONTECHNOLOGIES ON WHICH****OUR PRODUCTS RELY COULD HAVE A MATERIALADVERSE EFFECT ON US**

             Ourproducts currently run only on Microsoft Windows NT® servers. In addition, ourproducts use other Microsoft Corporation technologies, including MicrosoftExchange Server® and Microsoft SQL Server®. A decline in market acceptance forMicrosoft technologies or the increased acceptance of other server technologiescould cause us to incur significant development costs and could have a materialadverse effect on our ability to market our current products. Although webelieve that Microsoft technologies will continue to be widely used bybusinesses, we cannot assure you that businesses will adopt these technologiesas anticipated or will not in the future migrate to other computingtechnologies that we do not currently support. In addition, our products andtechnologies must continue to be compatible with new developments in Microsofttechnologies.

**OUR FUTURE BUSINESS PROSPECTS DEPEND IN PART ON OUR ABILITYTO MAINTAIN AND****IMPROVE OUR CURRENT PRODUCTS AND DEVELOPNEW PRODUCTS**

             Webelieve that our future business prospects depend in large part on our abilityto maintain and improve our current products and to develop new products on atimely basis. Our products will have to achieve market acceptance, maintaintechnological competitiveness and meet an expanding range of end-user customerrequirements. As a result of the complexities inherent in our products, majornew products and product enhancements require long development and testingperiods. We may not be successful in developing and marketing, on a timely andcost effective basis, product enhancements or new products that respond totechnological change, evolving industry standards or end-user customerrequirements. We may also experience difficulties that could delay or preventthe successful development, introduction or marketing of product enhancements,and our new products and product enhancements may not achieve marketacceptance. Significant delays in the general availability of new releases ofour products or significant problems in the installation or implementation of newreleases of our products could have a material adverse effect on our business,financial condition or results of operations.

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

             Ifthe demand for interaction management software of the type we license does notgrow within each of our three targeted markets, our ability to grow ourbusiness could be materially adversely affected. All of our revenues have beengenerated from licenses of our Interaction Center Platformä software orcomplementary products, and related support, educational and professionalservices. We expect these products and services to account for the majority ofour revenues for the foreseeable future. Although we believe demand for thefunctions performed by our products is high, and demand has grown in recentyears, particularly among call centers, the market for our products andservices is still emerging. Further, our growth plans require us tosuccessfully 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**

             Webelieve that establishing and maintaining brand and name recognition iscritical for attracting, retaining and expanding end–user customers inour target markets. We also believe that the importance of reputation and namerecognition will increase as competition in our market increases. Promotion andenhancement of our name will depend on the effectiveness of our marketing andadvertising efforts and on our success in providing high–quality productsand related services, neither of which can be assured. If our end–usercustomers do not perceive our product or related services to be effective or ofhigh quality, our brand and name recognition would suffer which could have amaterial adverse effect on our business, financial condition or results ofoperations.

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

                           Ourproducts cannot currently meet the communications needs of organizations withmore than 500 users at a single call center location and cannot currently meetthe communication needs of organizations with more than 1,000 users at a singleenterprise location. As these organizations expand to include multiplelocations, our products can be customized to increase the number of telephonelines, extensions and users. We will need to adapt our software to serve largersingle–site organizations. Although we are currently developing and testing solutions that wouldenable our software to significantly increase the number of users that ourproducts can serve at a single location, we cannot assure you that we will beable to successfully introduce this technology into a currently availableversion of our products.  Further, wemay not be able to adapt our software in a timely or cost effective manner in away that will permit us to serve these customers. This inability could have amaterial adverse effect on our business, financial condition or results of operations.

**OUR MAIN SUPPLIERS OF VOICE PROCESSING BOARDS MAY BECOMEUNWILLING OR UNABLE TO CONTINUE TO MANUFACTURE AND SUPPLY US WITH VOICEPROCESSING BOARDS, REQUIRING US TO INTRODUCE A SUBSTITUTE SUPPLIER WHICH COULDPROVE DIFFICULT OR COSTLY**

             DialogicCorporation, a subsidiary of Intel Corporation, and AcuLab plc are our primarysuppliers of the voice processing boards that are used by a majority of ourend-user customers the operation of  ourproducts.  If a majority of futureend-user customers desire to utilize the voice processing boards to enable ourproducts and these suppliers become unable or unwilling to continue tomanufacture and supply these voice processing boards in the volume, price andtechnical specifications we require, then we would have to adapt our productsto a substitute supplier.  We may not beable to successfully introduce voice processing boards made by a substitutesupplier into the available versions of our products. In addition, introducinga substitute supplier of voice processing boards could result in unforeseenadditional product development or customization costs and could also introducehardware and software operating or compatibility problems. We cannot assure youthat these issues will not affect product shipments, will not be costly tocorrect, will not damage our reputation in the markets in which we operate, orwill not have a material adverse affect on our business, financial condition orresults of operations.

             Inaddition, Dialogic Corporation’s CT MediaTM offers some of the functionalitythat our Interaction Center Platformäproducts provide and consequently could make it easier for competitors orpotential competitors to provide products competitive with ours. If CT MediaTMwere to become an industry standard, our failure to adopt it could disadvantageus in competitive situations.  Inaddition, although neither of our primary suppliers of voice processing boardsnor their affiliates currently offer a product that competes with ourInteraction Center Platformäproducts, they could potentially develop a competitive or superior product.

**WE MAY NOT BE ABLE TO PROTECT OUR PROPRIETARY RIGHTSADEQUATELY, WHICH COULD****ALLOW THIRD PARTIES TO COPY OR OTHERWISEOBTAIN AND USE OUR TECHNOLOGY WITHOUT****AUTHORIZATION**

             Weregard our software products as proprietary. In an effort to protect ourproprietary rights, we rely primarily on a combination of copyright, trademarkand trade secret laws, as well as licensing and other agreements withconsultants, suppliers, strategic and OEM partners, resellers and end–usercustomers, and employee and third–party non–disclosure agreements.These laws and agreements provide only limited protection of our proprietaryrights. In addition, we have not signed agreements containing these types ofprotective provisions in every case, and the contractual provisions that are inplace and the protection they provide vary and may not provide us with adequateprotection in all circumstances. Although we have filed patent applicationsdirected to several inventions embodied in our software products, we currentlyhold no patents. We hold seven U.S.trademark registrations and 12 foreign trademark registrations, and havenumerous other trademark applications pending worldwide, as well as havingcommon law rights in other trademarks and service marks.  We hold one registered copyright.Because our means of protecting our proprietary rights may not be adequate, itmay be possible for a third party to copy or otherwise obtain and use ourtechnology without authorization. A third party could also develop similartechnology independently. In addition, the laws of some countries in which wesell our products do not protect our software and intellectual property rightsto the same extent as the laws of the United States. Unauthorized copying, useor reverse engineering of our products could materially adversely affect ourbusiness, results of operations or financial condition.

             Welicense technology that is embedded in our products from others. If one or moreof these licenses terminates or cannot be renewed on satisfactory terms, wewould have to modify the affected products to use alternative technology oreliminate the affected product function, either of which could have a materialadverse effect on us.

**INFRINGEMENT CLAIMS COULD ADVERSELY AFFECT US**

             InJune 1999 and September 1999, the Company received letters from a competitor inthe call center market claiming that the Company's products utilizetechnologies 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 be able to enter into a licensingarrangement on terms and conditions that would not have a material adverseeffect on the Company's business, financial condition or results of operations.

             InJune 2000 and July 2000 the Company received letters from two other competitorsin the call center market claiming that the Company's products utilizetechnologies pioneered and patented by those competitors.  Although the Company's patent counsel hasnot determined the validity of these patents, the Company is discussing thepossible licensing of certain technologies with these competitors.  The Company cannot assure you that theseclaims can be resolved amicably without litigation, or that it will be able toenter into licensing arrangements on terms and conditions that would not have amaterial adverse effect on the Company's business, financial condition orresults of operations.

             Otherthird parties could claim that our technology infringes their proprietaryrights. As the number of software products in our target markets increases andthe functionality of these products overlap, we believe that softwaredevelopers may face infringement claims. For example, various patent rightshave been asserted against interfaces between PBX hardware and computer networksystems. Although we believe that our products do not infringe any of thesepatents because, among other reasons, our products are designed to replace PBXsand not to create such interfaces, if these patents were interpreted broadly,claims of infringement of these patents could have a material adverse affect onus.

             Infringementclaims, even if without merit, can be time consuming and expensive to defend. Athird party asserting infringement claims against us or our customers withrespect to our current or future products may require us to enter into costlyroyalty arrangements or litigation, or otherwise materially adversely affectus.

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

             Oursuccess depends in large part on the continued service of our key personnel,particularly Dr. Donald E. Brown, our Chief Executive Officer andprincipal stockholder, and Dr. Michael D. Gagle, our Chief Scientist. Theloss of the services of either of these individuals or any key personnel couldhave a material adverse effect on our business, financial condition or resultsof operations.  We do not have key man lifeinsurance on any of our employees.  Ourfuture success also depends on our ability to attract, train, assimilate andretain additional qualified personnel. Competition for persons with skills inthe software industry is intense, particularly for those with relevanttechnical and/or sales experience. We cannot assure you that we will be able toretain our key employees or that we can attract, train, assimilate or retainother highly qualified personnel in the future.

**OUR WORKFORCE REDUCTION AND FINANCIAL PERFORMANCE MAYADVERSELY AFFECT THE MORALE AND PERFORMANCE OF OUR PERSONNEL AND OUR ABILITY TOHIRE NEW PERSONNEL**

             Inconnection with our effort to streamline operations, reduce costs andrationalize our staffing and structure, we had a reduction in the worldwideworkforce of approximately ten percent. There have been and may continue to be substantial costs associated withthe workforce reduction related to severance and other employee-related  costs, and our restructuring plan may yieldunanticipated consequences, such as attrition beyond our planned reduction inworkforce.  As a result of thesereductions, our ability to respond to unexpected challenges may be impaired andwe may be unable to take advantage of new opportunities. The reduction in workforcemay reduce employee morale and may create concern among existing employeesabout job security, which may lead to increased turnover.  This reduction in headcount may subject usto the risk of litigation.  In addition,recent trading levels of our common stock have decreased the value of the stockoptions granted to employees pursuant to our stock option plans.  As a result of these factors, our remainingpersonnel may seek employment with larger, more established companies orcompanies they perceive as having less volatile stock prices.

**WE MAY PURSUE ACQUISITIONS THAT BY THEIR NATURE PRESENT RISKSAND THAT MAY NOT****BE SUCCESSFUL**

             Inthe future we may pursue acquisitions to diversify our product offerings andcustomer base or for other strategic purposes. We have no prior history ofmaking acquisitions and we cannot assure you that any future acquisitions willbe successful. The following are some of the risks associated with acquisitionsthat could have a material adverse effect on our business, financial conditionor results of operations:
-We  cannot assure that any acquired businesses will achieve anticipated revenues,  earnings or cash flow.  -We  may be unable to integrate acquired businesses successfully and realize  anticipated economic, operational and other benefits in a timely manner, particularly  if we acquire a business in a market in which we have limited or no current  expertise, or with a corporate culture different from our own. If we are  unable to integrate acquired businesses successfully, we could incur  substantial costs and delays or other operational, technical or financial  problems.  -Acquisitions  could disrupt our ongoing business, distract management, divert resources and  make it difficult to maintain our current business standards, controls and  procedures.  -We  may finance future acquisitions by issuing common stock for some or all of  the purchase price. This could dilute the ownership interests of our  stockholders. We may also incur additional debt or be required to recognize  amortization expense related to goodwill and other intangible assets  purchased in future acquisitions.  -We  would be competing with other firms, many of which have greater financial and  other resources, to acquire attractive companies. We believe this competition  will increase, making it more difficult to acquire suitable companies on  acceptable terms.
**OUR INTERNATIONAL OPERATIONS AND EXPANSION INVOLVE FINANCIALAND OPERATIONAL****RISKS**

             Theexpansion of our international operations will require significant managementattention and financial resources to establish additional foreign operations,hire additional personnel and recruit additional international resellers.Non-North American revenues accounted for 25%, 19%, and 16% of our totalrevenues in 2000, 1999, and 1998, respectively. To date, our products have beenlicensed outside North America primarily in Western Europe, South Africa, andAustralia. We are also expanding our marketing efforts in Japan, Korea, Chinaand Central and South America. We intend to continue to expand our internationaloperations and enter additional international markets. Revenues frominternational expansion may be inadequate to cover the expenses ofinternational expansion. In addition to foreign currency fluctuation risksdescribed in the next risk factor, other risks inherent in our internationalbusiness activities, in the countries in which we have licensed our products todate and in those countries in which we intend to expand, generally couldinclude the following:
-economic  and political instability;  -unexpected  changes in foreign regulatory requirements and laws;  -tariffs  and other trade barriers;  -timing,  cost and potential difficulty of adapting our software products to the local  language in those foreign countries that do not use the alphabet that English  uses, such as Japan, Korea and China;  -lack  of acceptance of our products in foreign countries;  -longer  sales cycles and accounts receivable payment cycles;  -potentially  adverse tax consequences; and  -restrictions  on the repatriation of funds.
**FLUCTUATIONS IN THE VALUE OF FOREIGN CURRENCIES COULD RESULTIN LOSSES**

             Ourinternational revenues are generally denominated in U.S. Dollars, but ourinternational expenses are generally denominated in local foreign currencies. Althoughforeign currency translation gains and losses have been immaterial to date,fluctuations in exchange rates between the U.S. Dollar and other currenciescould have a material adverse effect on our business, financial condition orresults of operations, and particularly on our operating margins. To date, wehave minimally sought to hedge the risks associated with fluctuations inexchange rates, but we may more actively undertake to do so in the future. Anyhedging techniques we implement in the future may not be successful. Exchangerate fluctuations could also make our products more expensive than competitiveproducts not subject to these fluctuations, which could adversely affect ourrevenues and profitability in international markets.
**OUR PRODUCTS COULD HAVE DEFECTS FOR WHICH WE ARE POTENTIALLYLIABLE AND WHICH****COULD RESULT IN LOSS OF REVENUE,INCREASED COSTS OR LOSS OF OUR CREDIBILITY OR****DELAY IN ACCEPTANCE OF OUR PRODUCTS INTHE MARKET**

             Ourproducts, including components supplied by others, may contain errors ordefects, especially when first introduced or when new versions are released.Despite internal product testing, we have in the past discovered softwareerrors in some of our products after their introduction. Errors in new productsor releases could be found after commencement of commercial shipments, and thiscould result in additional development costs, diversion of technical and otherresources from our other development efforts, or the loss of credibility withcurrent or future end-user customers. This could result in a loss of revenue ordelay in market acceptance of our products, which could have a material adverseeffect on our business, financial condition or results of operations.

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

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

**WE MAY NOT BE ABLE TO OBTAIN ADEQUATE FINANCING TO IMPLEMENTOUR GROWTH STRATEGY**

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

**OUR STOCK PRICE HAS BEEN AND COULD CONTINUE TO BE HIGHLYVOLATILE**
 Our  stock price has been and could continue to be highly volatile due to a number  of factors, including:   •actual  or anticipated fluctuations in our operating results;    •announcements  by us, our competitors or our end–user customers;    •changes  in financial estimates of securities analysts or investors regarding us, our  industry, our competitors or our end–user customers;    •technological  innovations by others;    •the  operating and stock price performance of other comparable companies or of our  competitors or end–user customers;    •the  low number of our shares typically traded in any trading session;    •the  availability for future sale, or sales, of a substantial number of shares of  our common stock in the public market; and    •general  market or economic conditions.
             This risk may be heightened becauseour industry is new and evolving, characterized by rapid technological changeand susceptible to the introduction of new competing technologies orcompetitors.

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

**Item 3. Qualitative andQuantitative Disclosures about Market Risk.**

             Wedevelop products in the United States and sell licenses in North America,Europe, the Asia/Pacific region, South Africa, and Central and South America.As a result, our financial results could be affected by various factors,including changes in foreign currency exchange rates or weak economicconditions in foreign markets. As all sales are currently made in U.S. dollars,a strengthening of the dollar could make our products less competitive inforeign markets.

             Wemanage our interest rate risk by maintaining an investment portfolio with debtinstruments of high credit quality and relatively short average maturities. Wealso manage interest rate risk by maintaining sufficient cash and cashequivalent balances such that we are typically able to hold our investments tomaturity.

**PART II. OTHER INFORMATION**

**Item 1.Legal Proceedings.**

             SeeNote 5 of our Notes to the Condensed Consolidated Financial Statements for adescription of correspondence received by us from competitors claiming that ourproducts utilize technologies pioneered and patented by them.

             Weare also subject to ordinary and routine claims, lawsuits and proceedingsincidental to our business, none of which is expected to be material to ourresults of operations, financial condition or cash flows.

**Item 2.Changes in Securities and Use of Proceeds.**

*Sales of Unregistered Securities During the Quarter*             None.

*Use of Proceeds*

             Theshares of our common stock issued in the initial public offering wereregistered on a Registration Statement on Form S-1 (Registration No. 333-79509)which was declared effective on September 22, 1999.  From the effective date of such Registration Statement to June30, 2001, the proceeds generated by our initial public offering have been usedas described in our report on Form 10-Q for the quarter ended September 30,1999 and in addition approximately $19.1 million has been used for workingcapital.

**Item 4. Submission of Mattersto a Vote of Security Holders.**

             Weheld our annual meeting of shareholders on May 15, 2001.  At that meeting, our shareholdersreelected  Michael P. Cullinane and JohnR. Gibbs as Directors of the Corporation to each serve a three year term anduntil his successor is elected and has qualified.  The final results of the votes taken at the meeting were asfollows:
 Votes For Votes Against Broker  Non-Votes Abstentions            Election  of Directors        Michael  P. Cullinane13,408,827 - - 13,091 John  R. Gibbs13,005,226 - - 416,692
In addition, the following directorscontinue in office until the annual meeting of shareholders in the yearindicated:
Donald  E. Brown2002Robert  A. Compton2002Jon  Anton, D.Sc.2003
 

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

(a)         Exhibits

             10.12 (iii) Letter of Assignmentbetween the Company and Jeremiah J. Fleming, dated as of April 1, 2001

             10.17 (ii) Modification and/orExtension Agreement , dated April 30, 2001, between the Company and KeyBank.

(b)        Reports on Form 8-K

                           No reports on Form8-K were filed during the quarter covered by this Form 10-Q.

 

 

 

 

 

**SIGNATURES**

Pursuant to the requirements of theSecurities Exchange Act of 1934, the Registrant has duly caused this report tobe signed on its behalf by the undersigned thereunto duly authorized.
  Interactive  Intelligence, Inc.  (Registrant)   Date:  August 14, 2001 By  /s/ Michael J. Tavlin  Michael  J. Tavlin  Senior  Vice President and Chief Financial Officer and Secretary  (Principal  Financial Officer and Duly Authorized Officer)