**UNITED STATES**

**SECURITIES AND EXCHANGECOMMISSION**

 

**Washington,D.C. 20549**

 

----

 

**FORM 10-Q**

 

**(Mark One)**

 

**ý****                                   QUARTERLYREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

 

**For thequarterly period ended March 31, 2005**

 

**Or**

 

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

 

**For thetransition period from                     to                    **

 

**CommissionFile Number 000-27385**

 

**INTERACTIVE INTELLIGENCE, INC.**

(Exactname of registrant as specified in its charter)

 

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

 

**7601Interactive Way**

**Indianapolis,Indiana 46278**

(Addressof principal executive offices)

 

**(317)872-3000**

(Registrant’stelephone number)

 

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

 

Yes ý    No o

 

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

 

Yes o    No ý

 

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

 

 

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TABLEOF CONTENTS

 
| PART I. FINANCIAL  INFORMATION | 3                                                                                                         |
|--------------------------------|-----------------------------------------------------------------------------------------------------------|
|                           |                                                                                                      |   |
| Item  1.                       | Condensed  Consolidated Balance Sheets as of March 31, 2005 and December 31, 2004                         | 3 |
|                           |                                                                                                      |   |
|                           | Condensed  Consolidated Statements of Operations for the three months ended March 31,  2005 and 2004      | 4 |
|                           |                                                                                                      |   |
|                           | Condensed  Consolidated Statement of Shareholders’ Equity for the three months ended  March 31, 2005 | 5 |
|                           |                                                                                                      |   |
|                           | Condensed  Consolidated Statements of Cash Flows for the three months ended March 31,  2005 and 2004      | 6 |
|                           |                                                                                                      |   |
|                           | Notes  to Condensed Consolidated Financial Statements                                                     | 7 |
|                           |                                                                                                      |   |
| Item  2.                       | Management’s  Discussion and Analysis of Financial Condition and Results of Operations               | 11 |
|                           |                                                                                                      |   |
| Item  3.                       | Quantitative  and Qualitative Disclosures About Market Risk                                               | 26 |
|                           |                                                                                                      |   |
| Item 4.                        | Controls and Procedures                                                                                   | 27 |
|                           |                                                                                                      |   |
| PART II. OTHER INFORMATION     | 27                                                                                                        |
|                           |                                                                                                      |   |
| Item 1.                        | Legal Proceedings                                                                                         | 27 |
|                           |                                                                                                      |   |
| Item  6.                       | Exhibits                                                                                                  | 28 |
|                           |                                                                                                      |   |
| SIGNATURES                     |                                                                                                      | 29 |

 

2

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**PART I. FINANCIALINFORMATION**

 

**Item 1.    CondensedConsolidated Financial Statements and Footnotes.**

 

**Interactive Intelligence, Inc.**

**Condensed Consolidated Balance Sheets**

**As of March 31, 2005 and December 31, 2004**

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

 
| ** **                                                                                                                                                           | ** ** | **March  31,  2005** | ** ** | **December  31,  2004** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------|------------|-------------------------|------------|
| ** **                                                                                                                                                           | ** ** | **(unaudited)**      | ** ** | **(Note 1**)            |       |
| **Assets**                                                                                                                                                           |       |                 |       |                    |       |
| Current assets:                                                                                                                                                      |       |                 |       |                    |       |
| Cash and cash equivalents                                                                                                                                            |       | $                    | 15,155     |                    | $          | 14,603 |   |
| Accounts receivable, net of allowance for  doubtful accounts of $470 in 2005 and $410 in 2004                                                                        |       | 10,119               |       | 10,251                  |       |
| Prepaid expenses                                                                                                                                                     |       | 2,919                |       | 2,119                   |       |
| Other current assets                                                                                                                                                 |       | 646                  |       | 836                     |       |
| Total current assets                                                                                                                                                 |       | 28,839               |       | 27,809                  |       |
| Property and equipment, net                                                                                                                                          |       | 4,039                |       | 4,071                   |       |
| Other assets, net                                                                                                                                                    |       | 629                  |       | 618                     |       |
| Total assets                                                                                                                                                         |       | $                    | 33,507     |                    | $          | 32,498 |   |
|                                                                                                                                                                 |       |                 |       |                    |       |
| **Liabilities and Shareholders’ Equity**                                                                                                                        |       |                 |       |                    |       |
| Current liabilities:                                                                                                                                                 |       |                 |       |                    |       |
| Line of credit                                                                                                                                                       |       | $                    | 3,000      |                    | $          | 3,000 |   |
| Accounts payable and accrued liabilities                                                                                                                             |       | 5,467                |       | 5,894                   |       |
| Accrued compensation and related expenses                                                                                                                            |       | 1,196                |       | 1,200                   |       |
| Deferred software revenues                                                                                                                                           |       | 4,693                |       | 4,484                   |       |
| Deferred services revenues                                                                                                                                           |       | 13,863               |       | 12,884                  |       |
| Total current liabilities                                                                                                                                            |       | 28,219               |       | 27,462                  |       |
| Shareholders’ equity:                                                                                                                                           |       |                 |       |                    |       |
| Preferred stock, no par value: 10,000,000  authorized; no shares issued and outstanding                                                                              |       | —               |       | —                  |       |
| Common stock, $0.01 par value; 100,000,000  authorized; 15,983,071 issued and outstanding at March 31, 2005, 15,926,594  issued and outstanding at December 31, 2004 |       | 160                  |       | 159                     |       |
| Additional paid-in capital                                                                                                                                           |       | 65,405               |       | 65,179                  |       |
| Accumulated deficit                                                                                                                                                  |       | (60,277              | )          | (60,302                 | )          |
| Total shareholders’ equity                                                                                                                                      |       | 5,288                |       | 5,036                   |       |
| Total liabilities and shareholders’ equity                                                                                                                      |       | $                    | 33,507     |                    | $          | 32,498 |   |

 

SeeAccompanying Notes to Condensed Consolidated Financial Statements

 

3

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**Interactive Intelligence, Inc.**

**CondensedConsolidated Statements of Operations (unaudited)**

**For theThree Months Ended March 31, 2005 and 2004**

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

 
| ** **                                    | ** ** | **Three Months Ended  March 31,** | ** ** |
|-----------------------------------------------|------------|-----------------------------------|------------|
| ** **                                    | ** ** | **2005**                          | ** ** | **2004** | ** ** |
| Revenues:                                     |       |                              |       |   |   |
| Software                                      |       | $                                 | 7,795      |   | $ | 6,993 |   |
| Services                                      |       | 6,798                             |       | 6,713 |   |
| Total revenues                                |       | 14,593                            |       | 13,706 |   |
| Cost of revenues:                             |       |                              |       |   |   |
| Software                                      |       | 632                               |       | 493 |   |
| Services                                      |       | 2,841                             |       | 2,855 |   |
| Total cost of revenues                        |       | 3,473                             |       | 3,348 |   |
| Gross profit                                  |       | 11,120                            |       | 10,358 |   |
| Operating expenses:                           |       |                              |       |   |   |
| Sales and marketing                           |       | 5,858                             |       | 5,028 |   |
| Research and development                      |       | 3,195                             |       | 3,278 |   |
| General and administrative                    |       | 2,063                             |       | 1,871 |   |
| Restructuring and other charges               |       | —                            |       | 16 |   |
| Total operating expenses                      |       | 11,116                            |       | 10,193 |   |
| Operating income                              |       | 4                                 |       | 165 |   |
| Interest income, net                          |       | 51                                |       | 7 |   |
| Income before income taxes                    |       | 55                                |       | 172 |   |
| Income taxes                                  |       | 30                                |       | 52 |   |
| Net income                                    |       | $                                 | 25         |   | $ | 120 |   |
|                                          |       |                              |       |   |   |
| Net income per share:                         |       |                              |       |   |   |
| Basic                                         |       | $                                 | 0.00       |   | $ | 0.01 |   |
| Diluted                                       |       | 0.00                              |       | 0.01 |   |
|                                          |       |                              |       |   |   |
| Shares used to compute net income per  share: |       |                              |       |   |   |
| Basic                                         |       | 15,958                            |       | 15,806 |   |
| Diluted                                       |       | 16,554                            |       | 16,700 |   |
|                                               |            |                                   |            |  |  |  |  |  |  |

 

SeeAccompanying Notes to Condensed Consolidated Financial Statements

 

4

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**Interactive Intelligence, Inc.**

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

**For theThree Months Ended March 31, 2005**

**(in thousands)**

 
| ** **                  | ** ** | ** **       | ** ** | ** **  | ** ** | **Additional**  | ** ** | ** **  | ** ** | ** ** | ** ** |
|-----------------------------|------------|------------------|------------|-------------|------------|-----------------|------------|-------------|------------|------------|------------|
| ** **                  | ** ** | **Common Stock** | ** ** | **Paid-in** | ** ** | **Accumulated** | ** ** | ** **  | ** ** |
| ** **                  | ** ** | **Shares**       | ** ** | **Amount**  | ** ** | **Capital**     | ** ** | **Deficit** | ** ** | **Total**  | ** ** |
| Balances, December 31, 2004 |       | 15,927           |       | $           | 159        |            | $          | 65,179      |       | $          | (60,302    | ) | $ | 5,036 |   |
|                        |       |             |       |        |       |            |       |        |       |       |       |
| Issuances of common stock   |       | 19               |       | —      |       | 57              |       | —      |       | 57         |       |
| Exercise of stock options   |       | 37               |       | 1           |       | 126             |       | —      |       | 127        |       |
| Stock-based compensation    |       | —           |       | —      |       | 43              |       | —      |       | 43         |       |
| Net income                  |       | —           |       | —      |       | —          |       | 25          |       | 25         |       |
|                        |       |             |       |        |       |            |       |        |       |       |       |
| Balances, March 31, 2005    |       | 15,983           |       | $           | 160        |            | $          | 65,405      |       | $          | (60,277    | ) | $ | 5,288 |   |

 

SeeAccompanying Notes to Condensed Consolidated Financial Statements

 

5

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**Interactive Intelligence, Inc.**

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

**For theThree Months Ended March 31, 2005 and 2004**

**(in thousands)**

 
| ** **                                                                         | ** ** | **Three Months Ended  March 31,** | ** ** |
|------------------------------------------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                                                         | ** ** | **2005**                          | ** ** | **2004** | ** ** |
| **Operating activities:**                                                          |       |                              |       |   |   |
| Net income                                                                         |       | $                                 | 25         |   | $ | 120 |   |
| Adjustments to reconcile net income to net  cash provided by operating activities: |       |                              |       |   |   |
| Depreciation                                                                       |       | 598                               |       | 873 |   |
| Amortization of deferred stock-based  compensation                                 |       | 43                                |       | 3 |   |
| Changes in operating assets and  liabilities:                                      |       |                              |       |   |   |
| Accounts receivable                                                                |       | 132                               |       | 1,610 |   |
| Prepaid expenses                                                                   |       | (800                              | )          | (302 | ) |
| Other current assets                                                               |       | 190                               |       | (221 | ) |
| Other assets                                                                       |       | (11                               | )          | (40 | ) |
| Accounts payable and accrued liabilities                                           |       | (427                              | )          | (12 | ) |
| Accrued compensation and related expenses                                          |       | (4                                | )          | 77 |   |
| Deferred software revenues                                                         |       | 209                               |       | (495 | ) |
| Deferred services revenues                                                         |       | 979                               |       | (151 | ) |
| Net cash provided by operating activities                                          |       | 934                               |       | 1,462 |   |
|                                                                               |       |                              |       |   |   |
| **Investing activities:**                                                          |       |                              |       |   |   |
| Purchases of property and equipment                                                |       | (566                              | )          | (364 | ) |
| Sales of available-for-sale investments                                            |       | —                            |       | 3,008 |   |
| Net cash provided (used) by investing  activities                                  |       | (566                              | )          | 2,644 |   |
|                                                                               |       |                              |       |   |   |
| **Financing activities:**                                                          |       |                              |       |   |   |
| Payments on line of credit, net                                                    |       | —                            |       | (1,600 | ) |
| Proceeds from issuance of common stock                                             |       | 57                                |       | 72 |   |
| Proceeds from stock options exercised                                              |       | 127                               |       | 84 |   |
| Net cash provided (used) by financing  activities                                  |       | 184                               |       | (1,444 | ) |
|                                                                               |       |                              |       |   |   |
| Net increase in cash and cash equivalents                                          |       | 552                               |       | 2,662 |   |
| Cash and cash equivalents, beginning of  period                                    |       | 14,603                            |       | 12,461 |   |
| Cash and cash equivalents, end of period                                           |       | $                                 | 15,155     |   | $ | 15,123 |   |
|                                                                               |       |                              |       |   |   |
| Cash paid for interest                                                             |       | $                                 | 1          |   | $ | 13 |   |
| Cash paid for taxes                                                                |       | 51                                |       | 3 |   |

 

SeeAccompanying Notes to Condensed Consolidated Financial Statements

 

6

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**Interactive Intelligence, Inc.**

**Notes to Condensed Consolidated Financial Statements**

**March31, 2005 and 2004 (unaudited)**

 

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

 

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

 

•                                            Contact Centers,

 

•                                            Enterprise IP Telephony,

 

•                                            Unified Communications, and

 

•                                            Self-service Automation.

 

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

 

Principal operations of theCompany commenced during 1997. Since then, the Company has establishedwholly-owned subsidiaries in Australia, France, the Netherlands and the UnitedKingdom, and more recently introduced its Vonexus subsidiary for GlobalEnterprise IP Telephony and Microsoft small business customer markets. TheCompany also currently has branch offices in Canada, Germany, Hong Kong, Japan,Korea, Malaysia, Singapore and Sweden. The Company markets its softwareapplications in the Americas; Europe, the Middle East and Africa (EMEA); andAsia/Pacific (APAC).

 

The accompanying unauditedfinancial statements have been prepared in conformity with accountingprinciples generally accepted in the United States of America for interimfinancial information and with the instructions for Form 10-Q and Article 10 ofRegulation S-X. Accordingly, certain information and footnote disclosuresnormally included in financial statements prepared in accordance withaccounting principles generally accepted in the United States of America havebeen condensed, or omitted, pursuant to the rules and regulations of theSecurities and Exchange Commission. In our opinion, the statements include alladjustments necessary (which are of a normal and recurring nature) for the fairpresentation of the results of the interim periods presented.

 

7

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The balance sheet atDecember 31, 2004 has been derived from the audited financial statements atthat date but does not include all of the information and footnotes required byaccounting principles generally accepted in the United States of America forcomplete financial statements.

 

These financial statementsshould be read in conjunction with our audited consolidated financialstatements for the year ended December 31, 2004, included in the Company’s Form10-K for the year ended December 31, 2004, filed with the Securities andExchange Commission on March 28, 2005. Our results of operations for anyinterim period are not necessarily indicative of the results of operations forany other interim period or for a full fiscal year.

 

**2.             Net Income Per Common Share**

 

Basic net income per shareis calculated based on the weighted-average number of outstanding common sharesin accordance with Financial Accounting Standards Board (FASB) Statement No.128, *Earnings per Share*. Diluted net incomeper share is calculated based on the weighted-average number of outstandingcommon shares plus the effect of dilutive potential common shares. Potentialcommon shares are composed of shares of common stock issuable upon the exerciseof stock options. The calculation of dilutive net income per share excludesshares underlying outstanding stock options with exercise prices that exceedthe average market price of the Company’s common stock for the period, as theeffect would be antidilutive.

 

The following table presentsthe calculation of basic and diluted net income per share (in thousands, exceptper share amounts):

 
| ** **                                               | ** ** | **Three Months Ended  March 31,** | ** ** |
|----------------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                               | ** ** | **2005**                          | ** ** | **2004** | ** ** |
| Net income, as reported (A)                              |       | $                                 | 25         |   | $ | 120 |   |
|                                                     |       |                              |       |   |   |
| Weighted average outstanding shares of  common stock (B) |       | 15,958                            |       | 15,806 |   |
| Dilutive effect of options to purchase  common stock     |       | 596                               |       | 894 |   |
| Common stock and common stock equivalent  shares (C)     |       | 16,554                            |       | 16,700 |   |
|                                                     |       |                              |       |   |   |
| Net income per share:                                    |       |                              |       |   |   |
| Basic (A/B)                                              |       | $                                 | 0.00       |   | $ | 0.01 |   |
| Diluted (A/C)                                            |       | 0.00                              |       | 0.01 |   |

 

The Company’s calculation ofdiluted net income per share for the three months ended March 31, 2005 and 2004excludes options to purchase 2.4 million and 1.2 million shares of commonstock, respectively, as their effect would be antidilutive.

 

**3.             Stock-Based Compensation**

 

The Company applies theintrinsic-value-based method of accounting prescribed by Accounting PrinciplesBoard (APB) Opinion No. 25, *Accounting for StockIssued to Employees*, and related interpretations including FASBInterpretation No. 44, *Accounting for CertainTransactions involving Stock Compensation, an interpretation of APB Opinion No.25*, to account for its fixed-plan stock options. Under this method,compensation expense is recorded on the date of grant only if the currentmarket price of the underlying stock exceeds the exercise price. FASB StatementNo. 123, *Accounting for Stock-BasedCompensation*and FASBStatement No. 148, *Accounting forStock-Based Compensation — Transition and Disclosure - an amendment of FASBStatement No. 123*, established accounting and disclosure requirementsusing a fair-value-based method of accounting for stock-based employeecompensation plans. As permitted by existing accounting standards, the Companyhas elected to continue to apply the intrinsic-value-based method of accountingdescribed above, and has adopted only the disclosure requirements of

 

8

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FASB StatementsNo. 123 and 148. See Note 6 below for a discussion of upcoming changes to theaccounting for stock-based compensation.

 

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

 
| ** **                                                                                                                          | ** ** | **Three Months Ended  March 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                                                                                                          | ** ** | **2005**                          | ** ** | **2004** | ** ** |
| Net income, as reported                                                                                                             |       | $                                 | 25         |   | $ | 120 |   |
| Add: Stock-based compensation expense  included in reported net income, net of related tax effects                                  |       | 43                                |       | 3 |   |
| Deduct: Total stock-based compensation  expense determined under fair-value-based method for all awards, net of  related tax effect |       | (789                              | )          | (769 | ) |
| Pro forma net loss                                                                                                                  |       | $                                 | (721       | ) | $ | (646 | ) |
|                                                                                                                                |       |                              |       |   |   |
| Net income (loss) per share:                                                                                                        |       |                              |       |   |   |
| Basic — as reported                                                                                                            |       | $                                 | 0.00       |   | $ | 0.01 |   |
| Diluted — as reported                                                                                                          |       | 0.00                              |       | 0.01 |   |
| Basic — pro forma                                                                                                              |       | (0.05                             | )          | (0.04 | ) |
| Diluted — pro forma                                                                                                            |       | (0.05                             | )          | (0.04 | ) |

 

**4.             Concentration of Credit Risk**

 

Tworesellers had greater than 10% concentration of accounts receivable and togetherrepresented 27% of accounts receivable as of March 31, 2005. No resellerrepresented greater than 10% of accounts receivable as of December 31, 2004.

 

**5.             Contingencies**

 

From time to time theCompany has received claims from competitors and other technology providersclaiming that the Company’s technology infringes their respective proprietaryrights. One such claim has resulted in a legal proceeding being filed againstthe Company, which is described below. The Company cannot assure you that thesematters can be resolved amicably without litigation, or that the Company willbe able to enter into licensing arrangements on terms and conditions that wouldnot have a material adverse effect on its business, financial condition orresults of operations.

 

On January 14, 2005, theCompany entered into a non-exclusive license agreement with a telecommunicationtechnology provider to use certain of its fax-related patents.  Pursuant to this agreement, the Company haspaid initial fees of $300,000 and recorded an accrual of $250,000 during thethree months ended December 31, 2004 for additional fees the Company believesare probable.  The Company may also payup to an additional $475,000 in license fees if certain specified criteria aremet.

 

In December 2002, theCompany received a letter from one of its resellers requesting indemnificationrelated to a request that the reseller had received for indemnification from acustomer. The Company has not received any correspondence from the resellersince May 2003 and does not believe that this matter will have a materialadverse effect on its business, financial condition or results of operations;however, the Company cannot provide assurance as to the outcome.

 

On September 30, 2003,Recursion Software, Inc. filed suit in Dallas County Court in Dallas, Texasagainst the Company alleging breach of contract and money due under claims ofquantum meruit and unjust enrichment. Recursion claims that the Companyincorporated Recursion software into one of its

 

9

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products in breach of the underlying license.On November 3, 2003, the Company had the case removed to Federal District Courtin Dallas, Texas and on January 28, 2004, Recursion asserted a copyrightinfringement claim against the Company, which was expanded in scope onSeptember 10, 2004. No dollar amount has been stated in the action. The Companybelieves that it has strong defenses to the claims and intends to vigorouslydefend against the action. The Company believes that this matter can beresolved without a material adverse effect on its business, financial conditionor results of operations; however, the Company cannot provide assurance as tothe outcome.

 

In November 2002, theCompany received a notification from the French government as a result of a taxaudit that had been conducted encompassing the years 1998, 1999, 2000 and 2001.These assessments claim various taxes are owed related to Value Added Tax (VAT)and corporation taxes in addition to what has previously been paid and accrued.As of March 31, 2005, the assessment related to VAT was approximately $3.0million and the assessment related to corporation taxes was approximately $389,000.The Company’s tax counsel has assessed the possibility of the Company payingthe assessment related to VAT as remote and the assessment related tocorporation taxes as reasonably possible. The Company has not accrued for theseamounts. The Company is appealing the assessments, but cannot assure you thatthese matters will be resolved without litigation or that it will not have topay some or all of the assessments.

 

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

 

**6.             Recent Accounting Pronouncements**

 

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

 

In December 2004, the FASBissued FASB Statement No. 153, *Exchanges of NonmonetaryAssets - an amendment of APB*Opinion*No. 29 (Accountingfor Nonmonetary Transactions)*. FASB Statement No. 153 requires thatexchanges of nonmonetary assets be measured based on the fair value of theassets exchanged. Further, it expands the exception for nonmonetary exchangesof similar productive assets to nonmonetary assets that do not have commercialsubstance. The provisions of FASB Statement No. 153 are effective fornonmonetary asset exchanges occurring in fiscal periods beginning after June15, 2005. The adoption of the provisions of FASB Statement No. 153 is notexpected to have a material impact on the Company’s consolidated financialposition or results of operations.

 

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

 

10

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

 

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

 

**Forward-Looking Information**

 

Certain statements in thisForm 10-Q contain “forward-looking” information (as defined inSection 27A of the Securities Act of 1933, as amended and Section 21Eof the Securities Exchange Act of 1934, as amended) that involve risks anduncertainties which may cause actual results to differ materially from thosepredicted in the forward-looking statements. Forward-looking statements canoften be identified by their use of such verbs as “expects,” “anticipates,” and“believes” or similar verbs or conjugations of such verbs. If any of ourassumptions on which the statements are based prove incorrect or shouldunanticipated circumstances arise, our actual results could materially differfrom those anticipated by such forward-looking statements. The differencescould be caused by a number of factors or combination of factors, including,but not limited to, the “Certain factors that may affect our future operatingresults” described herein and the Risk Factors described in our Securities andExchange Commission filings, including the Form 10-K filing for the yearended December 31, 2004.

 

**Overview**

 

We are a leading provider ofsoftware applications for contact centers and plan to leverage that leadershipposition to provide mission critical VoIP applications to enterprises. Ourcustomers are in a wide variety of fields including financial institutions,government, healthcare and retail, among others. We are a global softwareprovider with presence in: North America; Europe, Middle East and Africa(EMEA); and Australia and other Asia/Pacific countries (APAC).

 

**Financial Highlights**

 

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

 

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

 
| **Period**              | ** ** | ** ** | **Revenues** | ** ** | **% Growth** | ** ** |
|-------------------------|------------|------------|--------------|------------|--------------|------------|
| Three months ended:     |       |       |         |       |         |
| March 31, 2005          |       | $          | 14.6         |       | 2            | %          |
| December 31, 2004       |       | 14.4       |         | 7          |         |
| September 30, 2004      |       | 13.4       |         | (2         | )            |
| June 30, 2004           |       | 13.6       |         | —     |         |
| March 31, 2004          |       | 13.7       |         | 6          |         |
|                    |       |       |         |       |         |
| Year ended December 31: |       |       |         |       |         |
| 2004                    |       | $          | 55.1         |       | 7            | %          |
| 2003                    |       | 51.5       |         | 8          |         |

 

Our experience is that oncecompanies have implemented our software and the personnel at these companiesexperience the capabilities and efficiencies of our software, these companiesincrease their technology spending for our software. However, we cannot assureyou that this will continue to be the case. Future licensing to new customersis dependent on the economy and whether companies will allocate their resourcesto upgrade their systems.

 

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Revenues recognized in thethree months ended March 31, 2005 increased $887,000 over revenues for thethree months ended March 31, 2004. Beginning in the first quarter of 2004, webegan offering perpetual licenses to our new customers and therefore therecognition of revenues on new contracts signed in 2004 was acceleratedcompared to how revenues were previously recognized under typical annuallyrenewable licenses. Because the three months ended March 31, 2004 was the firstquarter the perpetual contracts were offered, there was not yet a largepercentage of perpetual contracts during that quarter. In the three monthsended March 31, 2005, 63% of the software revenues recognized were related toperpetual license agreements compared to 39% of the software revenues in thethree months ended March 31, 2004.

 

We formed a new subsidiary,Vonexus, on July 1, 2004. Vonexus is focused on selling a complete IP-basedphone system, including hardware, to Microsoft-based small and medium-sizedbusinesses. As a result of the formation of Vonexus and this new market focus,we have experienced higher expenses in sales and marketing since the thirdquarter of 2004. In the first quarter of 2005 we recognized our first revenuesrelated to Vonexus, which were minimal. We expect the higher sales andmarketing costs to continue. However, we expect to record additional revenuesin 2005 from Vonexus, which will partially offset these additional expenses. Wemay also incur additional costs of revenues related to hardware costs and, as aconsequence, if Vonexus sales become significant, our gross profits as apercentage of revenues may decline.

 

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

 

We had approximately $15.2 millionof cash and cash equivalents as of March 31, 2005. We had borrowings under aline of credit of $3.0 million as of March 31, 2005, which has since beenrepaid in full. We believe that if our revenues increase, our accountsreceivable are collected timely and our expenses remain controlled, we willmaintain or increase our liquidity position. If revenues decrease, or if we areunable to collect our account receivable balances from our customers on atimely basis, our liquidity position may weaken, which would result in the needto raise capital, either through the capital markets or debt financings.

 

**Historical Results of Operations**

 

The following table presentscertain financial data, derived from our unaudited statements of operations, asa percentage of total revenues for the periods indicated. The operating resultsfor the three months ended March 31, 2005 and 2004 are not necessarilyindicative of the results that may be expected for the full year or for anyfuture period.

 

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

 

**Comparisonof Three Months Ended March 31, 2005 and 2004**

 

***Revenues***

 

*Software Revenues*

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

 

The increase in softwarerevenues for the three months ended March 31, 2005 compared to the three monthsended March 31, 2004, was related primarily to an increase in the percentage ofperpetual license agreements we recognized in 2005. Beginning in the firstquarter of 2004, we began offering perpetual licenses to our new customers andtherefore the recognition of revenues on new contracts signed in 2004 wasaccelerated compared to how revenues were recognized under annually renewablelicenses in 2004. Because the three months ended March 31, 2004 was the firstquarter the perpetual contracts were offered, there was not yet a largepercentage of perpetual contracts during that quarter. In the three monthsended March 31, 2005, 63% of the software revenues recognized were related toperpetual license agreements compared to 39% of the software revenues in thethree months ended March 31, 2004.

 

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*Services Revenues*

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

 

Services revenues remained relativelyconstant for the three months ended March 31, 2005 compared to the three monthsended March 31, 2004.  Our servicesrevenues should grow as we sign and install new customers and as existingcustomers continue to renew licenses and pay for maintenance on our softwareapplications. For the three months ended March 31, 2005, maintenance revenuesgrew 15% over the three months ended March 31, 2004, however, other servicesrevenue (such as education and global services revenues) declined during thethree months ended March 31, 2005 compared to the three months ended March 31,2004. The percent of services revenues to total revenues decreased slightly dueto the increase in software revenues.

 

***Cost of Revenues***

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

 

Costs of software consistprimarily of product and software royalties paid to third parties for the useof their technologies in our products, hardware costs related to Vonexus and,to a lesser extent, software packaging costs, which include product media,duplication and documentation. Costs of software can fluctuate depending onwhich software applications are licensed to our customers, the third partytechnology, if any, which is licensed and the number of Vonexus systems sold.The increase in the software costs for the three months ended March 31, 2005compared to the three months ended March 31, 2004 was due to increasedroyalties for third party software and Vonexus hardware.

 

Costs of services consistprimarily of compensation expenses for technical support, education andprofessional services personnel, hardware costs related to InteractiveIntelligence and other costs associated with supporting our resellers andcustomers. These costs remained relatively constant for the three months endedMarch 31, 2005 compared to the three months ended March 31, 2004.

 

***Gross Profit***

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

 

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

 

***Operating Expenses***

 

*Sales and Marketing*

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

 

Sales and marketing expensesare comprised primarily of compensation expense, travel, marketing, entertainmentand other related expenses. These expenses increased for the three months endedMarch 31, 2005 compared to March 31, 2004. As anticipated and discussed in our Form10-K for the year ended December 31, 2004, the majority of this increase was dueto payroll expenses and other costs associated with Vonexus, our wholly-ownedsubsidiary. As described previously under Financial Highlights, we expect theseVonexus costs to continue, although we expect to record increased revenues fromVonexus in the second quarter to offset some of the increased expenses.

 

*Research and Development*

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

 

Research and developmentexpenses are comprised primarily of compensation expenses.  Research and development expenses decreased slightlyfor the three months ended March 31, 2005 compared to March 31, 2004 due to adecrease in staffing and lower depreciation expense as certain of our assetsbecome fully depreciated, partially offset by increased software purchases and increasedcosts of localization of our software.

 

## *General and Administrative*

##  

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

 

General andadministrative expenses are comprised of compensation expense and non-allocableexpenses including bad debt, legal and other professional service fees. Generaland administrative expenses increased for the three months ended March 31,2005 compared to March 31, 2004. This increase was the result of higherpayroll expenses due to increased staffing and an increase in other officeexpenses as well as a decrease in gains from foreign exchange. This increasewas partially offset by decreases in depreciation, premiums for corporateinsurance and legal services.

 

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***Interest Income, Net***

 

The majority of interestincome, net is made up of interest earned from investments and interest-bearingcash accounts. Interest expense, which is not material for any periodsreported, is also included in interest income, net. Interest earnings improvedduring the three months ended March 31, 2005 compared to the three months endedMarch 31, 2004 as shown below.

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

 

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

 

**Liquidity and Capital Resources**

 

In 1999 we raised cashthrough an initial public offering that provided net proceeds of $34.9 million.In 2001 we received an equity investment that yielded $15 million in cash. Inaddition, we generate cash from the collections we receive related to licensingour application software and from annual license renewals, maintenance andsupport and other services revenues. We also have in place a $3 million line ofcredit, which we fully utilized as of March 31, 2005, all of which was repaidin full subsequent to March 31, 2005. We use cash primarily for paying ouremployees (including salaries, commissions, benefits and severance), leasing officespace, reimbursing travel expenses, paying insurance premiums and payingvendors for services rendered and supplies purchased.

 

We determine liquidity bycombining cash and cash equivalents and short-term investments net of our lineof credit borrowings as shown in the table below. Our total liquidity positionimproved as of March 31, 2005 compared with our position as of December 31, 2004.We did not have any short-term investments at March 31, 2005 or December 31,2004. We believe that our current liquidity position, when combined with ouranticipated cash flows from operations, will be sufficient to satisfy our cashneeds over the next 12 months. If cash flows from operations are less thananticipated or we have additional cash needs (such as an unfavorable outcome inlegal proceedings), our liquidity may not be sufficient to cover our needs. Inthis case, we may be forced to raise additional capital, either through thecapital markets or debt financings. We may not be able to receive favorableterms in raising this capital.

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

 

Our operating activitiesresulted in net cash provided of $934,000 and $1.5 million for the three monthsended March 31, 2005 and 2004, respectively. For the three months ended March31, 2005, the decrease in cash provided from operating activities was a resultof an increase in deferred revenues, offset by an increase in prepaid expensesand a decrease in accounts payable.

 

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

 

We purchased property andequipment with a cost of $566,000 and $364,000 in the three months ended March 31,2005 and 2004, respectively. These purchases related mainly to in-housetechnology.

 

**Critical Accounting Policies andEstimates**

 

We believe there are threeaccounting policies that are important to understanding our historical andfuture performance, as these policies affect the reported amounts of revenuesand are the more significant areas involving management’s judgments andestimates. These critical accounting policies and estimates relate to revenuerecognition, the allowance for doubtful accounts receivable and research anddevelopment. These policies, and our procedures related to these policies, aredescribed below.

 

***Sources of Revenues and RevenueRecognition Policy***

 

We generate softwarerevenues from licensing the right to use our software applications and generateservices revenues primarily from annual renewal fees, annual maintenance fees,educational services and professional services. We believe both of thesesources of revenues are critical to our financial statements because of theirmateriality to our statements as a whole and because of the judgment requiredin determining if revenue recognition criteria have been met.

 

*Software Revenues*

 

Our software licenseagreements are either annually renewable or perpetual. For any revenues to berecognized from a software license agreement, the following criteria must bemet:

 

•                                            persuasive evidence of an arrangement exists;

 

•                                            the fee is fixed or determinable;

 

•                                            collection is probable; and

 

•                                            delivery has occurred.

 

For an annually renewablesoftware license agreement, upon meeting the revenue recognition criteriaabove, we recognize a majority of the initial license fees under theseagreements as software revenues ratably over the initial license period, whichis generally 12 months, and the remainder of the initial license fees arerecognized as services revenues over the same time period.

 

For a perpetual softwarelicense agreement, upon meeting the revenue recognition criteria above, weimmediately recognize as software revenues the amount of initial license feesif sufficient vendor specific objective evidence exists to support allocating aportion of the total fee to the undelivered elements of the arrangement. Ifsufficient vendor specific objective evidence of the fair value of theundelivered elements does not exist, we recognize the initial license fee assoftware revenues ratably over the initial term of the maintenance agreement,which is generally 12 months but at times may be more than 12 months because maintenancebegins when the licenses are downloaded which is typically within six months ofthe contract date.

 

*Services Revenues*

 

Services revenues arerecognized for annually renewable software license agreements and perpetualsoftware license agreements. For annually renewable software licenseagreements, the allocation of the initial order between software revenues andservices revenues is based on the actual renewal fee. After the initial licenseperiod, our customers may renew their license agreement for an additionalperiod, typically 12 months, by paying a renewal fee. Under perpetual softwarelicense agreements, we recognize annual maintenance fees as services revenuesratably over the post-contract maintenance period, which is typically 12months.

 

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We also generate revenuesfrom other services that we provide to our resellers and customers. Theseadditional revenues include fees for educational services and professionalservices. Revenues from educational services, which consist of training coursesfor resellers and customers, and professional services, which includeimplementing our products for a customer, are recognized as the relatedservices are performed.

 

***Allowance for Doubtful AccountsReceivable***

 

We adjust our allowance fordoubtful accounts for each reporting period based on an average bad debtexpense to revenue ratio and based on a detailed analysis of our accountsreceivable at the end of that period. In estimating the allowance for doubtfulaccounts, we primarily consider the age of the reseller’s or customer’sreceivable and also consider the creditworthiness of the reseller or customer,the economic conditions of the customer’s industry, and general economicconditions, among other factors. If payment is not made timely, we contact thecustomer or reseller to try to obtain payment. If this is not successful, weinstitute other collection practices such as generating collection letters,involving our sales representatives and ultimately terminating the customer’sor reseller’s access to future upgrades, licenses and customer support. Onceall collection efforts are exhausted, the receivable is written off against theallowance for doubtful accounts.

 

***Research and Development***

 

Through March 31, 2005, allresearch and development expenditures have been expensed as incurred. Based onour product development process and technological feasibility, the date atwhich capitalization of development costs may begin is established uponcompletion of a working model. Costs incurred between completion of the workingmodel and the point at which the product is ready for general release have beeninsignificant.

 

**Certain factorsthat may affect our future operating results are set forth below:**

 

**THE OVERALLECONOMIC CLIMATE MAY BE WEAK**

 

Our products typicallyrepresent substantial capital commitments by customers and involve apotentially long sales cycle. As a result, customer purchase decisions may besignificantly affected by a variety of factors, including general economictrends in the allocation of capital spending budgets to communication software,services and systems, lengthened sales cycles, customer approval processes, andmarket conditions, which have resulted in many of our customers delaying and/orreducing their capital spending related to information systems. If the economyweakens, demand for our products could decrease, resulting in lower revenues.

 

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

 

Since the first quarter of2004, we have reported net income. We have historically incurred losses and maydo so again in the future. We incurred net losses of $5.9 million and $7.7million in 2003 and 2002, respectively. At March 31, 2005, we had accumulatednet losses since inception of $60.3 million. We intend to continue to makesignificant investments in our research and development, marketing, services,sales operations and our new subsidiary, Vonexus. In addition, as discussed inNote 6 of Notes to Consolidated Financial Statements, FASB Statement No. 123Rwill have an adverse effect on our operating results when we implement it. As aresult, we may experience losses and/or negative cash flow from operations infuture quarters.

 

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**OURQUARTERLY OPERATING RESULTS HAVE VARIED SIGNIFICANTLY**

 

Our operating results havevaried significantly from quarter to quarter and may continue to do so in thefuture depending on a number of factors affecting us or our industry, includingmany that are beyond our control. As a result, we believe that period-to-periodcomparisons of our operating results are not necessarily meaningful, and youshould not rely on them as an indication of our future performance. Inaddition, our operating results in a future quarter or quarters may fall belowexpectations of securities analysts or investors and, as a result, the price ofour common stock may fluctuate.

 

Because we do not know if orwhen our potential customers will place orders and finalize licenses, andbecause it is difficult to predict the mix of annually renewable licenses andperpetual licenses in a quarter, we cannot accurately forecast our licensingactivity, our revenues and our operating results for future quarters. Werecognize revenues from different licenses over different periods depending onthe satisfaction of the requirements of relevant accounting literature,including AICPA Statement of Position 97-2, Statement of Position 98-9, SECStaff Accounting Bulletin (SAB) 104, and all related AICPA Technical PracticeAids (5100.38 - 5100.76). As a result, our quarterly revenues andoperating results depend on many factors, including the type of license, thesize, quantity and timing of orders received for our products during eachquarter, the delivery of the related software and our expectations regardingcollection. If a large number of orders or several large orders do not occur orare deferred or delayed, our revenues in a quarter could be substantiallyreduced. This risk is heightened by the significant investment and executivelevel decision-making typically involved in our customers’ decisions to licenseour products. Since a large portion of our operating expenses, includingsalaries and rent, is fixed and difficult to reduce or modify in a short timeperiod, our business, financial condition or results of operations could bematerially adversely affected if revenues do not meet our expectations.

 

Our limited number ofproducts, changes in pricing policies, the timing of development completion,and announcement and sale of new or upgraded versions of our products are someof the additional factors that could cause our revenues and operating resultsto vary significantly from quarter to quarter.

 

**WE HAVE ALENGTHY PRODUCT SALES CYCLE WHICH HAS CONTRIBUTED AND MAY CONTINUE TOCONTRIBUTE TO THE VARIABILITY OF QUARTERLY OPERATING RESULTS**

 

We have generallyexperienced a lengthy product sales cycle, averaging approximately six to ninemonths. The lengthy sales cycle is one of the factors that has caused, and mayin the future continue to cause, our software revenues and operating results tovary significantly from quarter to quarter, which could affect the market priceof our common stock. The lengthy sales cycle also makes it difficult for us toforecast product license revenues. Because of the unique characteristics of ourproducts, our prospective customers’ decisions to license our products oftenrequire significant investment and executive-level decision making. We believethat many companies currently are not aware of the benefits of interactionmanagement software of the type that we license or of our products andcapabilities. For this reason, we must provide a significant level of educationto prospective customers about the use and benefits of our products, which cancause potential customers to take many months to make these decisions. As aresult, sales cycles for customer orders vary substantially from customer tocustomer. Excessive delay in product sales could materially adversely affectour business, financial condition or results of operations.

 

The length of the salescycle for customer orders depends on a number of other factors over which wehave little or no control, including:

 

•                                            a customer’s budgetary constraints;

 

•                                            the timing of a customer’s budget cycles;

 

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

 

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

 

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

 

As the complexity of ourproduct technology and our reseller and other third party relationships haveincreased, the management of those relationships and the negotiation ofcontractual terms sufficient to protect our rights and limit our potentialliabilities have become more complicated, and we expect this trend to continuein the future. In addition, the formation of our wholly-owned subsidiary,Vonexus, which offers through resellers a whole product solution, has addedcomplexity to those third party relationships. As a result, our inability tosuccessfully manage these relationships or negotiate sufficient contractualterms could have a material adverse effect on us.

 

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

 

The market for our softwareapplications is highly competitive and, because there are relatively lowbarriers to entry in the software market, we expect competitive pressures tocontinue to be a risk to our ongoing success in the market. In addition,because our industry is evolving and characterized by rapid technologicalchange, it is difficult for us to predict whether, when and by whom newcompeting technologies or new competitors may be introduced into our markets.Currently, our competition comes from several different market segments,including computer telephony platform developers, computer telephonyapplications software developers and telecommunications equipment vendors. Wecannot provide assurance that we will be able to compete effectively againstcurrent and future competitors. In addition, increased competition or othercompetitive pressures may result in price reductions, reduced margins or lossof market share, any of which could have a material adverse effect on ourbusiness, financial condition or results of operations.

 

Many of our current andpotential competitors have longer operating histories, significantly greaterresources, greater name recognition and a larger installed base of customersthan we do. As a result, these competitors may be able to respond to new oremerging technologies and changes in customer requirements more effectivelythan we can, or to devote greater resources to the development, promotion andsale of products than we can. In addition, for a number of our largercompetitors, the product segment in which they currently compete with us is asmall portion of their overall offering. These competitors might be willing andable to dramatically cut prices in our segment in order to protect or growother segments that are more important to their overall business. Current andpotential competitors have established, and may in the future establish,cooperative relationships among themselves or with third parties, includingmergers or acquisitions, to increase the ability of their products to addressthe needs of our current or prospective customers. If these competitors were toacquire significantly increased market share, it could have a material adverseeffect on our business, financial condition or results of operations.

 

**WE MAY NOTBE ABLE TO GROW OUR BUSINESS IF WE DO NOT MAINTAIN SUCCESSFUL RELATIONSHIPSWITH OUR RESELLERS AND PARTNERS AND CONTINUE TO RECRUIT AND DEVELOP ADDITIONALSUCCESSFUL RESELLERS AND PARTNERS**

 

Our ability to achieverevenue growth in the future will depend in part on our success in maintainingsuccessful relationships with our existing and future resellers and partnersand in recruiting and training additional resellers and partners. We relyprimarily on resellers to market and support our products and plan oncontinuing to rely heavily on such partners in the future. We are stilldeveloping our reseller and distribution networks and may be unable to attractadditional resellers with both voice and data expertise or appropriate partnersthat will be able to market our products effectively and that will be qualifiedto provide timely and cost-effective customer support and service. We generallydo not have long-term or exclusive agreements with our resellers or partners,and the loss of specific larger resellers or partners or a significant

 

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number of resellers or partners couldmaterially adversely affect our business, financial condition or results ofoperations.

 

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

 

The market for our productsis characterized by rapid technological change, frequent new productintroductions and enhancements, uncertain product life cycles and changingcustomer demands. The introduction of products embodying new technologies andthe emergence of new industry standards could render existing products obsoleteor unmarketable and cause us to incur significant development costs and preventus from attracting new customers.

 

**A DECLINEIN MARKET ACCEPTANCE FOR MICROSOFT TECHNOLOGIES ON WHICH OUR PRODUCTS RELYCOULD HAVE A MATERIAL ADVERSE EFFECT ON US**

 

Our products currently runonly on Microsoft Windows operating systems. In addition, our products useother Microsoft technologies, including Microsoft Exchange Server and MicrosoftSQL Server. A decline in market acceptance for Microsoft technologies or theincreased acceptance of other server technologies could cause us to incursignificant development costs and could have a material adverse effect on ourability to market our current products. Although we believe that Microsofttechnologies will continue to be widely used by businesses, we cannot assureyou that businesses will adopt these technologies as anticipated or will not inthe future migrate to other competing technologies that we do not currentlysupport. In addition, our products and technologies must continue to becompatible with new developments in Microsoft technologies.

 

**OUR FUTUREBUSINESS PROSPECTS DEPEND IN PART ON OUR ABILITY TO MAINTAIN AND IMPROVE OURCURRENT PRODUCTS AND DEVELOP NEW PRODUCTS**

 

We believe that our futurebusiness prospects depend in large part on our ability to maintain and improveour current software applications and to develop new software applications on atimely basis. Our software applications will have to continue to achieve marketacceptance, maintain technological competitiveness and meet an expanding rangeof customer requirements. As a result of the complexities inherent in ourapplications, major new applications and application enhancements require longdevelopment and testing periods. We may not be successful in developing andmarketing, on a timely and cost effective basis, application enhancements ornew software applications that respond to technological change, evolvingindustry standards or customer requirements. We may also experiencedifficulties that could delay or prevent the successful development,introduction or marketing of application enhancements, and our new applicationsand application enhancements may not achieve market acceptance. Significantdelays in the general availability of new releases of our software applicationsor significant problems in the installation or implementation of new releasesof our applications could have a material adverse effect on our business, financialcondition or results of operations.

 

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

 

If the demand forinteraction management software of the type we license does not grow withineach of our four targeted markets, our financial results and ability to growour business could be materially adversely affected. All of our revenues havebeen generated from licenses of our Interaction Center Platform 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, the market for our

 

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products and services is still emerging.Further, our growth plans require us to successfully attract enterprise andservice provider customers in significantly larger numbers than we havehistorically achieved.

 

**IF OURCUSTOMERS DO NOT PERCEIVE OUR PRODUCTS OR THE RELATED SERVICES PROVIDED BY USOR OUR RESELLERS OR PARTNERS TO BE EFFECTIVE OR OF HIGH QUALITY, OUR BRAND ANDNAME RECOGNITION WILL SUFFER**

 

We believe that establishingand maintaining brand and name recognition is critical for attracting,retaining and expanding customers in our target markets. We also believe thatthe importance of reputation and name recognition will increase as competitionin our market increases. Promotion and enhancement of our name will depend onthe effectiveness of our marketing and advertising efforts and on our successin providing high-quality products and related services, neither of which can beassured. If our customers do not perceive our products or related services tobe effective or of high quality, our brand and name recognition would sufferwhich could have a material adverse effect on our business, financial conditionor results of operations.

 

**WE MAY NOTBE ABLE TO PROTECT OUR PROPRIETARY RIGHTS ADEQUATELY, WHICH COULD ALLOW THIRDPARTIES TO COPY OR OTHERWISE OBTAIN AND USE OUR TECHNOLOGY WITHOUTAUTHORIZATION**

 

We regard our softwareproducts as proprietary. In an effort to protect our proprietary rights, werely primarily on a combination of copyright, trademark and trade secret laws,as well as patents, licensing and other agreements with consultants, suppliers,strategic and partners, resellers and customers, and employee and third-partynon-disclosure agreements. These laws and agreements provide only limitedprotection of our proprietary rights. It may be possible for a third party tocopy or otherwise obtain and use our technology without authorization. A thirdparty could also develop similar technology independently. In addition, thelaws of some countries in which we license our products do not protect oursoftware and intellectual property rights to the same extent as the laws of theUnited States. Unauthorized copying, use or reverse engineering of our productscould materially adversely affect our business, results of operations orfinancial condition.

 

We license technology thatis embedded in our products. If one or more of these licenses terminates orcannot be renewed on satisfactory terms, we would have to modify the affectedproducts to use alternative technology or eliminate the affected productfunction, either of which could have a material adverse effect on us.

 

**INFRINGEMENTCLAIMS COULD ADVERSELY AFFECT US**

 

Third parties have claimedor may in the future 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 additional infringement claims. See Note 5 of Notes toCondensed Consolidated Financial Statements for a description of contingencies.

 

Infringement claims, even ifwithout merit, can be time consuming and expensive to defend. A third partyasserting infringement claims against us or our customers with respect to ourcurrent or future products may require us to enter into costly royaltyarrangements or litigation, or otherwise materially adversely affect us.

 

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**WE DEPENDON KEY PERSONNEL AND WILL NEED TO RETAIN AND RECRUIT SKILLED PERSONNEL, FORWHICH COMPETITION IS INTENSE, TO CONDUCT AND GROW OUR BUSINESS EFFECTIVELY**

 

Our success depends in largepart on the continued service of our key personnel, particularlyDr. Donald E. Brown, our Chief Executive Officer and principalstockholder. The loss of the services of Dr. Donald E. Brown or other keypersonnel could have a material adverse effect on our business, financialcondition or results of operations. Our future success also depends on ourability to attract, train, assimilate and retain additional qualifiedpersonnel. Competition for persons with skills in the software industry isintense, particularly for those with relevant technical and/or sales experience.We cannot assure you that we will be able to retain our key employees or thatwe can attract, train, assimilate or retain other highly qualified personnel inthe future.

 

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

 

In the future we may pursueacquisitions to diversify our product offerings and customer base or for otherstrategic purposes. We have no prior history of making material acquisitionsand we cannot assure you that any future acquisitions will be successful. Thefollowing are some of the risks associated with acquisitions that could have amaterial adverse effect on our business, financial condition or results ofoperations:

 

•                                            We cannot assure that any acquired businesseswill achieve anticipated revenues, earnings or cash flow.

 

•                                            We may be unable to integrate acquiredbusinesses successfully and realize anticipated economic, operational and otherbenefits in a timely manner, particularly if we acquire a business in a marketin which we have limited or no current expertise, or with a corporate culturedifferent from our own. If we are unable to integrate acquired businessessuccessfully, we could incur substantial costs and delays or other operational,technical or financial problems.

 

•                                            Acquisitions could disrupt our ongoingbusiness, distract management, divert resources and make it difficult tomaintain our current business standards, controls and procedures.

 

•                                            We may finance future acquisitions by issuingcommon stock for some or all of the purchase price. This could dilute theownership interests of our stockholders. We may also incur additional debt orbe required to recognize expense related to intangible assets recorded infuture acquisitions.

 

•                                            We may be competing with other firms, many ofwhich have greater financial and other resources, to acquire attractivecompanies, making it more difficult to acquire suitable companies on acceptableterms.

 

**OURINTERNATIONAL OPERATIONS INVOLVE FINANCIAL AND OPERATIONAL RISKS**

 

Our international operationsrequire significant management attention and financial resources to establishand operate, including hiring appropriate personnel and recruiting effectiveinternational resellers. Non-North American revenues accounted for 27%, 22% and13% of our total revenues for the three months ended March 31, 2005 and theyears ended December 31, 2004 and 2003, respectively. We have marketing effortsin the Americas, EMEA and APAC. We intend to continue to emphasize ourinternational operations and we may enter additional international markets.Revenues from international operations may be inadequate to cover the expensesof those operations. In addition to foreign currency fluctuation risks, otherrisks inherent in our international business activities may include thefollowing:

 

•                                            economic and political instability;

 

•                                            unexpected changes in foreign regulatoryrequirements and laws;

 

•                                            tariffs and other trade barriers;

 

•                                            timing, cost and potential difficulty ofadapting our software products to the local language in those foreign countriesthat do not use the alphabet that English uses, such as Japan, Korea and China;

 

•                                            lack of acceptance of our products in foreigncountries;

 

•                                            longer sales cycles and accounts receivablepayment cycles;

 

•                                            potentially adverse tax consequences;

 

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•                                            restrictions on the repatriation of funds;

 

•                                            acts of terrorism; and

 

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

 

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

 

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

 

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

 

Our products, includingcomponents supplied by others, may contain errors or defects, especially whenfirst introduced or when new versions are released. Despite internal producttesting, we have in the past discovered software errors in some of our productsafter their introduction. Errors in new products or releases could be foundafter commencement of commercial shipments, and this could result in additionaldevelopment costs, diversion of technical and other resources from our otherdevelopment efforts, or the loss of credibility with current or futurecustomers. This could result in a loss of revenue or delay in market acceptanceof our products, which could have a material adverse effect on our business,financial condition or results of operations.

 

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

 

Our software runs on aWindows 2000 or Windows 2003 server and for telephone call processing usesvoice processing boards or third party VoIP media processing software such asIntel HMP software.  Our server softwarealso operates in a complex network environment with database servers, emailservers and other third party systems. Because of this complexity, it may bemore prone to performance interruptions for our customers than traditionalhardware-based products. Performance interruptions at our customer sites, mostof which currently do not have back-up systems, could affect demand for ourproducts or give rise to claims against us.

 

**WE MAY NOTBE ABLE TO OBTAIN ADEQUATE FINANCING TO IMPLEMENT OUR STRATEGY**

 

Successful implementation ofour strategy may require continued access to capital. If we do not generatesufficient cash from operations, our growth could be limited unless we are ableto obtain capital through additional debt or equity financings. We cannot assureyou that debt or equity financings will be available as required foracquisitions or other needs. Even if financing is available, it may not be onterms 

 

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that are favorable to us or sufficient for ourneeds. If we are unable to obtain sufficient financing, we may be unable tofully implement our growth strategy.

 

**OUR STOCKPRICE HAS BEEN AND COULD CONTINUE TO BE HIGHLY VOLATILE**

 

Our stock price has been andcould continue to be highly volatile due to a number of factors, including:

 

•                                            actual or anticipated fluctuations in ouroperating results;

 

•                                            announcements by us, our competitors or ourcustomers;

 

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

 

•                                            technological innovations by others;

 

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

 

•                                            the low number of our shares typically tradedin 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 heightenedbecause our industry is relatively new and evolving, characterized by rapidtechnological change and susceptible to the introduction of new competingtechnologies or competitors.

 

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

 

**OUR COMMONSTOCK IS SUBJECT TO VARIOUS LISTING REQUIREMENTS**

 

The various markets operatedby The NASDAQ Stock Market have quantitative maintenance criteria for continuedlisting of common stock. We may be delisted from one or more NASDAQ markets ifwe fail to comply with the criteria. While we believe that we currently meetcriteria for listing on a market operated by The NASDAQ Stock Market, we canoffer no assurance that our common stock will continue to meet the variouscriteria for continued listing on any market operated by The NASDAQ StockMarket. Any delisting may result in a reduction in the liquidity of our commonstock, which may have a material adverse effect on the price of our commonstock.

 

**REGULATORYCHANGES MADE TO GENERALLY ACCEPTED ACCOUNTING PRINCIPLES OR CORPORATEGOVERNANCE MATTERS MAY IMPACT OUR BUSINESS**

 

Revisions to generallyaccepted accounting principles will require us to review our accounting andfinancial reporting procedures in order to ensure continued compliance withrequired policies. From time to time, such changes may have a short-term impacton our reporting, and these changes may impact market perception of ourfinancial condition. In addition, legislative changes, and the perception thesechanges create, can have a material, adverse effect on our business. Forexample:

 

•                                            pending or new legislation, such as theSarbanes-Oxley 404 regulations, may lead to an increase in our costs related toaudits in particular and regulatory compliance generally; and

 

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

 

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**OUREXECUTIVE OFFICERS AND DIRECTORS CONTROL US AND MAY MAKE DECISIONS THATSHAREHOLDERS DO NOT CONSIDER TO BE IN THEIR BEST INTERESTS**

 

Our current directors andexecutive officers together beneficially own more than 50% of our outstandingcommon stock. Accordingly, these shareholders are able to control us throughtheir ability to determine the outcome of the election of our directors, amendour Restated Articles of Incorporation and By-Laws and take other actionsrequiring the vote or consent of shareholders, including mergers, going privatetransactions and other extraordinary transactions, and the terms of any ofthese transactions. The ownership position of these shareholders may have theeffect of delaying, deterring or preventing a change in control or a change inthe composition of our board of directors.

 

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

 

Our Restated Articles ofIncorporation and By-Laws contain provisions that may have the effect ofdelaying, deferring or preventing a change in control of us, may discouragebids at a premium over the market price of our common stock and may adverselyaffect the market price of our common stock, and the voting and other rights ofthe holders of our common stock. These provisions include:

 

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

 

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

 

•                                            prohibiting shareholders from calling aspecial meeting of shareholders;

 

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

 

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

 

The Indiana corporation lawcontains business combination provisions that, in general, prohibit for fiveyears any business combination with a beneficial owner of 10% or more of ourcommon stock unless the holder’s acquisition of the stock was approved inadvance by our board of directors. The Indiana corporation law also containscontrol share acquisition provisions that limit the ability of certainshareholders to vote their shares unless their control share acquisition wasapproved in advance.

 

**WE CANNOTPREDICT EVERY EVENT AND CIRCUMSTANCE THAT MAY IMPACT OUR BUSINESS AND,THEREFORE, THE RISKS AND UNCERTAINTIES DISCUSSED ABOVE MAY NOT BE THE ONLY ONESYOU SHOULD CONSIDER**

 

The risks and uncertaintiesdiscussed above are in addition to those that apply to most businessesgenerally. In addition, as we continue to grow our business, we may encounterother risks of which we are not aware at this time. These additional risks maycause serious damage to our business in the future, the impact of which wecannot estimate at this time.

 

**Item 3.    Quantitative and Qualitative Disclosuresabout Market Risk.**

 

We develop products in theUnited States and license our products in the Americas, EMEA and APAC. As aresult, our financial results could be affected by various factors, includingchanges in foreign currency exchange rates or weak economic conditions inforeign markets. As most sales are currently made in U.S. dollars, a strengtheningof the dollar could make our products less competitive in foreign markets.Additionally, as our business matures in foreign markets, we may offer ourproducts and services in certain

 

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other local currencies. As a result, we willbe subject to foreign currency fluctuations, which may have an adverse affecton our company.

 

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

 

**Item 4.    Controls and Procedures.**

 

We maintain a set ofdisclosure controls and procedures that are designed to ensure that informationrequired to be disclosed by us in the reports filed by us under the SecuritiesExchange Act of 1934, as amended (Exchange Act) is recorded, processed,summarized and reported within the time periods specified in the SEC’s rulesand forms. We carried out an evaluation, under the supervision and with theparticipation of our management, including our President and Chief ExecutiveOfficer and our Chief Financial Officer and Treasurer, of the effectiveness ofthe design and operation of our disclosure controls and procedures as of March 31,2005 pursuant to Rule 13a-15(b) of the Exchange Act. Based on that evaluation,our President and Chief Executive Officer and our Chief Financial Officer andTreasurer concluded that our disclosure controls and procedures were effective.

 

There have been no changesin our internal control over financial reporting that occurred during thequarter ended March 31, 2005 that have materially affected, or are reasonablylikely to materially affect, our internal control over financial reporting.

 

**PARTII. OTHER INFORMATION**

 

**Item 1.    Legal Proceedings.**

 

From time to time we havereceived claims from competitors and other technology providers claiming thatour technology infringes their proprietary rights. One such claim has resultedin a legal proceeding being filed against us, which is described below. Wecannot assure you that these matters can be resolved amicably withoutlitigation, or that we will be able to enter into licensing arrangements onterms and conditions that would not have a material adverse effect on ourbusiness, financial condition or results of operations.

 

In December 2002, wereceived a letter from one of our resellers requesting indemnification relatedto a request that the reseller had received for indemnification from acustomer. We have not received any correspondence from the reseller since May 2003and do not believe that this matter will have a material adverse effect on ourbusiness, financial condition or results of operations; however, we cannotprovide assurance as to the outcome.

 

On September 30, 2003,Recursion Software, Inc. filed suit in Dallas County Court in Dallas, Texasagainst us alleging breach of contract and money due under claims of quantummeruit, unjust enrichment and infringement. Recursion claims that we incorporatedRecursion software into one of our products in breach of the underlyinglicense. On November 6, 2003, we had the case removed to Federal District Courtin Dallas, Texas and on January 28, 2004, Recursion asserted a copyrightinfringement claim against us, which was expanded in scope on September 10,2004. No dollar amount has been stated in the action. We believe that we havestrong defenses to the claims and intend to vigorously defend against theaction. We believe that this matter can be resolved without a material adverseeffect on our business, financial condition or results of operations; however,we cannot provide assurance as to the outcome.

 

In November 2002, wereceived a notification from the French government as a result of a tax auditthat had been conducted encompassing the years 1998, 1999, 2000 and 2001. Theseassessments claim

 

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various taxes are owed related to Value AddedTax (VAT) and corporation taxes in addition to what has previously been paidand accrued. As of March 31, 2005, the assessment related to VAT wasapproximately $3.0 million and the assessment related to corporation taxes wasapproximately $389,000. Our tax counsel has assessed the possibility of uspaying the assessment related to VAT as remote and the assessment related tocorporation taxes as reasonably possible. We have not accrued for theseamounts. We are appealing the assessments, but cannot assure you that thesematters will be resolved without litigation or that we will not have to paysome or all of the assessments.

 

From time to time, we are alsoinvolved in certain intellectual property claims and legal proceedings in theordinary course of conducting our business. While the ultimate liabilitypursuant to these actions cannot currently be determined, we believe these claimsand legal proceedings will not have a material adverse effect on our business,financial condition or results from operations. Litigation in general, andintellectual property litigation in particular, can be expensive and disruptiveto normal business operations. Moreover, the results of complex legalproceedings are difficult to predict

 

**Item 6.    Exhibits.**

 

(a)           Exhibits

 

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

 

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

 

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

 

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

 

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

 

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

 

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**SIGNATURES**

 

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

 

 
|               |   | Interactive  Intelligence, Inc.                                                                                                                                   |   |
|--------------------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|
|               |   | (Registrant)                                                                                                                                                      |   |
|               |   |                                                                                                                                                              |   |
|               |   |                                                                                                                                                              |   |
| Date: May 10, 2005 | By     | /s/  Stephen R. Head                                                                                                                                              |   |
|               |   | Stephen  R. Head                                                                                                                                                  |   |
|               |   | *Chief Financial Officer, Vice President of  Finance and Administration, Secretary and Treasurer  (Principal Financial Officer and Principal Accounting Officer)* |   |

 

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