**UNITED
      STATES**


**SECURITIES
      AND EXCHANGE COMMISSION**


**Washington,
      D.C. 20549**





**____________**





**FORM
      10-Q**


**(Mark
      One)**





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





**For
      the quarterly period ended June 30, 2007**





**Or**





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





**For
      the transition period from ____________to____________**





**Commission
      File Number: 000-27385**







**INTERACTIVE
      INTELLIGENCE, INC.**


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





**Indiana**
              (State
                or other jurisdiction
              of
                incorporation or organization)
            
            **35-1933097**
              (I.R.S.
                Employer Identification No.)**7601
                Interactive Way**
              **Indianapolis,
                IN 46278**
              (Address
                of principal executive offices, including zip code)**(317)
                872-3000**
              (Registrant’s
                telephone number, including area code)





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




Indicate
      by check mark whether the
      registrant is a large accelerated filer, an accelerated filer or a
      non-accelerated filer. See definition of “accelerated filer and large
      accelerated filer” as defined in Rule 12b-2 of the Exchange Act. (Check
      one):




Large
                  accelerated filer
              o
              Accelerated
                  filer
              **þ**
              Non-accelerated
                  filer
              o


****




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





As
      of July 31, 2007, there were 17,506,612 shares outstanding of the registrant’s
      common stock, $0.01 par value.



















**TABLE
      OF CONTENTS**








**PART
                I. FINANCIAL INFORMATION**
            **Page**Item
                1.
            Financial
                Statements.Condensed
                Consolidated Balance Sheets as of June 30,
                2007 and December 31, 2006
            3Condensed
                Consolidated Statements of Income for
                the Three and Six Months Ended June 30, 2007 and 2006
            4Condensed
                Consolidated Statement of Shareholders’ Equity
                for the Six Months Ended June 30, 2007
            5Condensed
                Consolidated Statements of Cash Flows for the
                Six Months Ended June 30, 2007 and 2006
            6Notes
                to Condensed Consolidated Financial
                Statements
            7Item
                2.
            Management’s
                Discussion and Analysis of Financial Condition
                and Results of Operations.
            15Item
                3.
            Quantitative
                and Qualitative Disclosures About Market
                Risk.
            25Item
                4.
            Controls
                and Procedures.
            25**PART
                II. OTHER INFORMATION**Item
                1.
            Legal
                Proceedings.
            25Item
                1A.
            Risk
                Factors.
            25Item
                4.
            Submission
                of Matters to a Vote of Security
                Holders.
            26Item
                6.
            Exhibits.
            26**SIGNATURES**
            28


-
          2
          -
 **-
          back to table of contents -**


**PART
      I. FINANCIAL INFORMATION**




**Item
                  1.**
              **Condensed
                  Consolidated Financial Statements and Notes
                  to Condensed Consolidated Financial
                  Statements.**


**Interactive
      Intelligence, Inc.**


**Condensed
      Consolidated Balance Sheets**


**As
      of June 30, 2007 and December 31, 2006**


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





**June
                  30,**
                **2007**
            
            
            **December
                  31,**
                **2006****(unaudited)**
            
            
            **(Note
                1)****Assets**Current
                assets:Cash
                and cash equivalents
            
            $
            18,449
            
            
            $
            13,531Short-term
                investments
            
            
            13,694
            
            
            
            13,555Accounts
                receivable, net of allowance for doubtful accounts of $776 at June
                30, 2007 and
              $596
                atDecember
                31, 2006
            
            
            24,084
            
            
            
            21,370Deferred
                tax assets, net
            
            
            1,314
            
            
            
            1,314Prepaid
                expenses
            
            
            5,442
            
            
            
            5,358Other
                current assets
            
            
            1,969
            
            
            
            1,818Total
                current assets
            
            
            64,952
            
            
            
            56,946Property
                and equipment, net
            
            
            6,830
            
            
            
            5,469Deferred
                tax assets, net
            
            
            3,686
            
            
            
            3,686Other
                assets, net
            
            
            1,736
            
            
            
            674Total
                assets
            
            $
            77,204
            
            
            $
            66,775**Liabilities
                and Shareholders’ Equity**Current
                liabilities:Accounts
                payable and accrued liabilities
            
            $
            8,972
            
            
            $
            7,885Accrued
                compensation and related expenses
            
            
            3,876
            
            
            
            3,825Deferred
                product revenues
            
            
            5,820
            
            
            
            5,910Deferred
                services revenues
            
            
            27,548
            
            
            
            24,877Total
                current liabilities
            
            
            46,216
            
            
            
            42,497Commitments
                and contingencies
            
            
            --
            
            
            
            --Shareholders’
                equity:Preferred
                stock, no par value: 10,000,000 shares authorized; no shares issued
                and
                outstanding
            
            
            --
            
            
            
            --Common
                stock, $0.01 par value: 100,000,000 shares authorized; 17,453,131
                issued
                and outstanding
              at
                June 30, 2007 and17,139,804
                issued and outstanding at December 31, 2006
            
            
            174
            
            
            
            171Additional
                paid-in capital
            
            
            75,310
            
            
            
            72,528Accumulated
                deficit
            
            
            (44,496
            )
            
            
            (48,421
            )Total
                shareholders’ equity
            
            
            30,988
            
            
            
            24,278Total
                liabilities and shareholders’ equity
            
            $
            77,204
            
            
            $
            66,775







*See
      Accompanying Notes to Condensed Consolidated Financial
      Statements*




-
          3
          -
 **-
          back to table of contents -**




**Interactive
      Intelligence, Inc.**


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


**For
      the Three and Six Months Ended June 30, 2007 and 2006**


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





**Three
                  Months Ended**
                **June
                  30,**
            
            
            **Six
                  Months Ended**
                **June
                  30,****2007**
            
            
            **2006**
            
            
            **2007**
            
            
            **2006****Revenues:**Product
            
            $
            14,447
            
            
            $
            9,586
            
            
            $
            26,708
            
            
            $
            18,447Services
            
            
            12,533
            
            
            
            9,667
            
            
            
            24,465
            
            
            
            18,736Total
                revenues
            
            
            26,980
            
            
            
            19,253
            
            
            
            51,173
            
            
            
            37,183**Cost
                of revenues:**Product
            
            
            3,500
            
            
            
            2,033
            
            
            
            5,941
            
            
            
            3,366Services
            
            
            5,245
            
            
            
            3,244
            
            
            
            10,042
            
            
            
            6,307Total
                cost of revenues
            
            
            8,745
            
            
            
            5,277
            
            
            
            15,983
            
            
            
            9,673Gross
                profit
            
            
            18,235
            
            
            
            13,976
            
            
            
            35,190
            
            
            
            27,510**Operating
                expenses:**Sales
                and marketing
            
            
            8,705
            
            
            
            6,855
            
            
            
            17,349
            
            
            
            13,734Research
                and development
            
            
            4,227
            
            
            
            3,292
            
            
            
            8,124
            
            
            
            6,414General
                and administrative
            
            
            3,285
            
            
            
            2,833
            
            
            
            6,350
            
            
            
            5,367Total
                operating expenses
            
            
            16,217
            
            
            
            12,980
            
            
            
            31,823
            
            
            
            25,515Operating
                income
            
            
            2,018
            
            
            
            996
            
            
            
            3,367
            
            
            
            1,995**Other
                income (expense):**Interest
                income, net
            
            
            384
            
            
            
            116
            
            
            
            856
            
            
            
            220Other
                expense, net
            
            
            (42
            )
            
            
            (12
            )
            
            
            (98
            )
            
            
            (64
            )Total
                other income, net
            
            
            342
            
            
            
            104
            
            
            
            758
            
            
            
            156Income
                before income taxes
            
            
            2,360
            
            
            
            1,100
            
            
            
            4,125
            
            
            
            2,151Income
                tax expense
            
            
            (103
            )
            
            
            (138
            )
            
            
            (200
            )
            
            
            (177
            )Net
                income
            
            $
            2,257
            
            
            $
            962
            
            
            $
            3,925
            
            
            $
            1,974**Net
                income per share:**Basic
            
            $
            0.13
            
            
            $
            0.06
            
            
            $
            0.23
            
            
            $
            0.12Diluted
            
            $
            0.12
            
            
            $
            0.05
            
            
            $
            0.20
            
            
            $
            0.11**Shares
                used to compute net income per share:**Basic
            
            
            17,401
            
            
            
            16,433
            
            
            
            17,325
            
            
            
            16,343Diluted
            
            
            19,291
            
            
            
            18,070
            
            
            
            19,265
            
            
            
            17,652








*See
      Accompanying Notes to Condensed Consolidated Financial
      Statements*





-
          4
          -
 **-
          back to table of contents -**





**Interactive
      Intelligence, Inc.**


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


**For
      the Six Months Ended June 30, 2007**


**(in
      thousands)**





**Common
                  Stock**
            
            
            **Additional**
              **Paid-in**
            
            
            **Accumulated****Shares**
            
            
            **Amount**
            
            
            **Capital**
            
            
            **Deficit**
            
            
            **Total**Balances,
                December 31, 2006
            
            
            17,139
            
            
            $
            171
            
            
            $
            72,528
            
            
            $
            (48,421
            )
            
            $
            24,278Issuances
                of common stock
            
            
            6
            
            
            
            --
            
            
            
            104
            
            
            
            --
            
            
            
            104Exercise
                of stock options
            
            
            308
            
            
            
            3
            
            
            
            1,204
            
            
            
            --
            
            
            
            1,207Stock-based
                compensation
            
            
            --
            
            
            
            --
            
            
            
            1,474
            
            
            
            --
            
            
            
            1,474Net
                income
            
            
            --
            
            
            
            --
            
            
            
            --
            
            
            
            3,925
            
            
            
            3,925Balances,
                June 30, 2007
            
            
            17,453
            
            
            $
            174
            
            
            $
            75,310
            
            
            $
            (44,496
            )
            
            $
            30,988








*See
      Accompanying Notes to Condensed Consolidated Financial
      Statements*




-
          5
          -
 **-
          back to table of contents -**




**Interactive
      Intelligence, Inc.**


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


**For
      the Six Months Ended June 30, 2007 and 2006**


**(in
      thousands)**





**Six
                Months Ended**
              **June
                  30,****2007**
            
            
            **2006****Operating
                activities:**Net
                income
            
            $
            3,925
            
            
            $
            1,974Adjustments
                to reconcile net income to net cash provided by operating
                activities:Depreciation
            
            
            1,231
            
            
            
            867Accretion
                of investment income
            
            
            (240
            )
            
            
            --Stock-based
                compensation expense related to stock options
            
            
            1,474
            
            
            
            1,166Loss
                on disposal of fixed assets
            
            
            -
            
            
            
            4Changes
                in operating assets and liabilities:Accounts
                receivable
            
            
            (2,714
            )
            
            
            (286
            )Prepaid
                expenses
            
            
            (84
            )
            
            
            (1,312
            )Other
                current assets
            
            
            (151
            )
            
            
            (380
            )Other
                assets
            
            
            (196
            )
            
            
            (31
            )Accounts
                payable and accrued liabilities
            
            
            1,087
            
            
            
            (148
            )Accrued
                compensation and related expenses
            
            
            51
            
            
            
            387Deferred
                product revenues
            
            
            (90
            )
            
            
            923Deferred
                services revenues
            
            
            2,622
            
            
            
            1,141Net
                cash provided by operating activities
            
            
            6,915
            
            
            
            4,305**Investing
                activities:**Purchases
                of available-for-sale investments
            
            
            (10,214
            )
            
            
            (6,829
            )Sales
                of available-for-sale investments
            
            
            10,315
            
            
            
            4,089Purchases
                of property and equipment
            
            
            (2,556
            )
            
            
            (1,035
            )Acquisition
                  of professional services division
            
            
            (853
            )
            
            
            --Net
                cash used in investing activities
            
            
            (3,308
            )
            
            
            (3,775
            )**Financing
                activities:**Proceeds
                from stock options exercised
            
            
            1,207
            
            
            
            1,676Proceeds
                from issuance of common stock
            
            
            104
            
            
            
            96Net
                cash provided by financing activities
            
            
            1,311
            
            
            
            1,772Net
                increase in cash and cash equivalents
            
            
            4,918
            
            
            
            2,302Cash
                and cash equivalents, beginning of period
            
            
            13,531
            
            
            
            11,551Cash
                and cash equivalents, end of period
            
            $
            18,449
            
            
            $
            13,853Cash
                paid for interest
            
            $
            --
            
            
            $
            7Cash
                paid for taxes
            
            
            78
            
            
            
            159








*See
      Accompanying Notes to Condensed Consolidated Financial
      Statements*




-
          6
          -
 **-
          back to table of contents -**




**Interactive
            Intelligence, Inc.**
 **Notes
            to Condensed Consolidated Financial Statements**
 **June
            30, 2007 and 2006 (unaudited)**
 
 **1.**
                  **THE
                      COMPANY**
  Interactive
            Intelligence, Inc. (the “Company“) is a leading provider of software
            applications for contact centers and is leveraging that leadership position
            to
            provide mission critical voice over Internet protocol (“VoIP”) applications to
            enterprises. The Company’s products are installed at international corporations,
            public agencies, telecommunication companies, distributed organizations,
            government and commercial enterprises. The Company participates in four
            distinct
            markets, all of whose needs are increasing for VoIP-based systems:
  ·
                  Contact
                      Centers
  ·
                  Enterprise
                      IP Telephony
  ·
                  Enterprise
                      Messaging
  ·
                  Self
                      Service Automation
  The
            Company commenced principal operations in 1994 and revenues were first
            recognized in 1997. Since then, the Company has established wholly-owned
            subsidiaries in Australia, France, the Netherlands and the United Kingdom.
            The
            Company also currently has international branch offices in Canada, Germany,
            Japan, Korea, Malaysia, Singapore and Sweden. The Company markets its
            software
            applications in the Americas, Europe, the Middle East, Africa, and
            Asia/Pacific.
 
 The
            accompanying unaudited condensed consolidated financial statements have
            been
            prepared in conformity with accounting principles generally accepted
            in the
            United States of America for interim financial information and with the
            instructions for Form 10-Q and Article 10 of Regulation S-X. Accordingly,
            certain information and footnote disclosures normally included in financial
            statements prepared in accordance with accounting principles generally
            accepted
            in the United States of America have been condensed, or omitted, pursuant
            to the
            rules and regulations of the Securities and Exchange Commission (the
“SEC”). In
            the Company’s opinion, the condensed consolidated financial statements include
            all adjustments necessary (which are of a normal and recurring nature)
            for the
            fair presentation of the results of the interim periods presented.
 
 The
            accompanying condensed consolidated balance sheet at December 31, 2006
            has been
            derived from the audited consolidated financial statements at that date
            but does
            not include all of the information and footnotes required by accounting
            principles generally accepted in the United States of America for complete
            financial statements.
 
 These
            condensed consolidated financial statements should be read in conjunction
            with
            the Company’s audited consolidated financial statements for the year ended
            December 31, 2006, included in the Company’s most recent Annual Report on Form
            10-K as filed with the SEC. The Company’s results of operations for any interim
            period are not necessarily indicative of the results of operations for
            any other
            interim period or for a full fiscal year.
  -
                7
                -
 **-
                back to table of contents -**
  **Interactive
            Intelligence, Inc.**
 **Notes
            to Condensed Consolidated Financial Statements (continued)**
 
 **2.**
                  **SUMMARY
                      OF SIGNIFICANT ACCOUNTING
                      POLICIES**
 
 *Principles
            of Consolidation*
 
 The
            accompanying condensed consolidated financial statements include the
            accounts of
            the Company and its wholly-owned subsidiaries after elimination of all
            significant intercompany accounts and transactions.
 
 *Use
            of Estimates*
 
 The
            preparation of the accompanying condensed consolidated financial statements
            in
            conformity with accounting principles generally accepted in the United
            States
            requires management to make estimates and assumptions that affect the
            amounts
            reported in the financial statements and accompanying notes. Despite
            management’s best effort to establish good faith estimates and assumptions,
            actual results could differ from these estimates.
 
 *Revenue
            Recognition*
 
 The
            Company generates product revenues from licensing the right to use its
            software
            applications and in certain instances providing hardware as a component
            of its
            solution, and generates services revenues primarily from annual support
            fees,
            annual renewal fees, professional services and educational
            services.
 
 *Product
            Revenues*
 
 The
            Company’s license agreements are either perpetual or annually
            renewable.  For any revenues to be recognized from a license
            agreement, the following criteria must be met:
 
 ·
                  Persuasive
                      evidence of an arrangement exists;
 
 ·
                  The
                      fee is fixed or determinable;
 
 ·
                  Collection
                      is probable; and
 
 ·      Delivery
            has occurred.
 
 For
            a
            perpetual license agreement, upon meeting the revenue recognition criteria
            above, the Company immediately recognizes as product revenues the amount
            of
            initial license fees if sufficient vendor specific objective evidence
            of fair
            value (“VSOE”) exists to support allocating a portion of the total fee to the
            undelivered elements of the arrangement. If sufficient VSOE of the undelivered
            elements does not exist, the Company recognizes the initial license fee
            as
            product revenues ratably over the initial term of the support agreement
            once
            support is the only undelivered element. The support period is generally
            12
            months but may be up to 18 months for initial orders because support
            begins when
            the licenses are downloaded, when support commences, or no more than
            six months
            following the contract date. The Company determines VSOE of support in
            perpetual
            agreements based on substantive renewal rates the customer must pay to
            renew the
            support. The VSOE of other services is based on amounts charged when
            the
            services are sold in stand-alone sales.
 
 For
            an
            annually renewable license agreement, which includes bundled support,
            upon
            meeting the revenue recognition criteria above, the Company recognizes
            a
            majority of the initial license fees under these agreements as product
            revenues
            ratably over the initial license period, which is generally 12 months,
            and the
            remainder of the initial license fees are recognized as services revenues
            over
            the same time period.
 
 The
            Company recognizes revenues related to any hardware sales when the hardware
            is
            delivered and all other revenue recognition criteria are met.
 
 *Services
            Revenues*
 
 Services
            revenues are primarily recognized for renewal fees and support related
            to
            annually renewable license agreements and support fees for perpetual
            license
            agreements. For annually renewable agreements, the allocation of the
            initial
            order between product revenues and services revenues is based on the
            average
            renewal rates of all time based contracts. The Company applies the allocation
            of
            product revenues and services revenues consistently to all annually renewable
            agreements. Under annually renewable license agreements, after the initial
            license period, the Company’s customers may renew their license agreement for an
            additional period, typically 12 months, by paying a renewal fee. The
            revenue for
            the annual renewal fees are all classified under services revenue and
            the
            revenue is recognized ratably over the contract period. Under perpetual
            license
            agreements, the Company recognizes annual support fees as services revenues
            ratably over the post-contract support period, which is typically 12
            months.
 
  -
                8
                -
 **-
                back to table of contents -**
  **Interactive
            Intelligence, Inc.**
 **Notes
            to Condensed Consolidated Financial Statements (continued)**
 
 The
            Company also generates revenues from other services that it provides
            to its
            partners and customers. These additional revenues include fees for professional
            services and educational services. Revenues from professional services,
            which
            include implementing the Company’s products for a customer, and educational
            services, which consist of training courses for partners and customers,
            are
            recognized as the related services are performed.
 
 *Stock-Based
            Compensation*
 
 The
            Company accounts for its employee and director stock options in accordance
            with
            Financial Accounting Standards Board (“FASB”) Statement of Financial Accounting
            Standards (“SFAS”) No. 123 (revised 2004), *Share-Based Payment* (“SFAS
            123R”) and the guidance of the SEC Staff Accounting Bulletin No. 107 (“SAB
            107”), which requires the measurement and recognition of compensation expense
            for all share-based payment awards made to employees and directors, based
            on
            fair values.  As permitted by SFAS 123R, the Company used the
            Black-Scholes option-pricing model as its method of valuation for share-based
            payment awards. The Company’s determination of fair value of share-based payment
            awards on the date of grant using an option-pricing model is affected
            by the
            Company’s stock price as well as assumptions regarding a number of highly
            complex and subjective variables. These variables include, but are not
            limited
            to, the Company’s expected stock price volatility over the term of the awards
            and an expected risk-free rate of return. If factors change and the Company
            uses
            different assumptions for estimating stock-based compensation expense
            in future
            periods, stock-based compensation expense may differ materially in the
            future
            from that recorded in the current period.
 
 Stock-based
            compensation expense for employee stock options recognized under SFAS
            123R for
            the three and six months ended June 30, 2007 was $806,000 and $1.5 million,
            respectively, compared to $668,000 and $1.2 million during the same periods
            in
            2006.
 
 *Income
            Taxes*
 
 Income
            taxes are accounted for under the asset and liability method. Deferred
            tax
            assets and liabilities are recognized for the future tax consequences
            attributable to differences between the financial statement carrying
            amounts of
            existing assets and liabilities and their respective tax bases and operating
            loss and tax credit carry-forwards. Deferred tax assets and liabilities
            are
            measured using enacted tax rates expected to apply to taxable income
            in the
            years in which those temporary differences are expected to be recovered
            or
            settled. The effect on deferred tax assets and liabilities of a change
            in tax
            rates is recognized in income in the period that includes the enactment
            date.
 
 SFAS
            No.
            109, *Accounting for Income Taxes* (“SFAS 109”), establishes financial
            accounting and reporting standards for the effect of income taxes. The
            Company
            is subject to income taxes in both the United States and numerous foreign
            jurisdictions. Significant judgment is required in evaluating the Company’s tax
            positions and determining its provision for income taxes. The objectives
            of
            accounting for income taxes are to recognize the amount of taxes payable
            or
            refundable for the current year and deferred tax liabilities and assets
            for the
            future tax consequences of events that have been recognized in an entity’s
            financial statements or tax returns. Variations in the actual outcome
            of these
            future tax consequences could materially impact the Company’s financial
            position, results of operations, or cash flows.
 
 In
            assessing the recoverability of deferred tax assets, management considers
            whether it is more likely than not that some portion or all of the deferred
            tax
            assets will not be realized. The ultimate realization of deferred tax
            assets is
            dependent upon generation of future taxable income during the periods
            in which
            temporary differences become deductible. Management considers projected
            future
            taxable income and tax planning strategies in making this assessment
            and
            ensuring that the deferred tax asset valuation allowance is adjusted
            as
            appropriate.
 
 See
            Note
            7 for further information on the Company’s income taxes.
 
 *Legal
            Proceedings*
 
 Liabilities
            for loss contingencies arising from claims, assessments, litigation,
            fines, and
            penalties and other sources are recorded when it is probable that a liability
            has been incurred and the amount of the assessment and/or remediation
            can be
            reasonably estimated. Legal costs incurred in connection with loss contingencies
            are expensed as incurred.
 
 *Reclassifications*
 
 Certain
            reclassifications have been
            made to prior year amounts to conform to the current period presentation.
            Prior
            to January 1, 2007, costs related to the development of the Company’s packaged
            solutions were included in cost of services. Beginning January 1, 2007,
            these
            costs have been reclassified from cost of services to research and
            development.
  -
                9
                -
 **-
                back to table of contents -**
  **Interactive
            Intelligence, Inc.**
 **Notes
            to Condensed Consolidated Financial Statements (continued)**
 
 **3.**
                  **NET
                      INCOME PER SHARE**
 
 Basic
            net
            income per share is calculated based on the weighted-average number of
            outstanding common shares in accordance with SFAS No. 128, *Earnings per
            Share*. Diluted net income per share is calculated based on the
            weighted-average number of outstanding common shares plus the effect
            of dilutive
            potential common shares. When the Company reports net income, the calculation
            of
            diluted net income per share excludes shares underlying outstanding stock
            options that would be antidilutive. Potential common shares are composed
            of
            shares of common stock issuable upon the exercise of stock options (in
            thousands, except per share amounts).
 
 **Three
                        Months Ended**
                      **June
                        30,**
                  
                  
                  **Six
                        Months Ended**
                      **June
                        30,****2007**
                  
                  
                  **2006**
                  
                  
                  **2007**
                  
                  
                  **2006**Net
                      income, as reported (A)
                  
                  $
                  2,257
                  
                  
                  $
                  962
                  
                  
                  $
                  3,925
                  
                  
                  $
                  1,974Weighted
                      average outstanding shares of common stock (B)
                  
                  
                  17,401
                  
                  
                  
                  16,433
                  
                  
                  
                  17,325
                  
                  
                  
                  16,343Dilutive
                      effect of employee stock options
                  
                  
                  1,890
                  
                  
                  
                  1,637
                  
                  
                  
                  1,940
                  
                  
                  
                  1,309Common
                      stock and common stock equivalents (C)
                  
                  
                  19,291
                  
                  
                  
                  18,070
                  
                  
                  
                  19,265
                  
                  
                  
                  17,652Net
                      income per share:Basic
                      (A/B)
                  
                  $
                  0.13
                  
                  
                  $
                  0.06
                  
                  
                  $
                  0.23
                  
                  
                  $
                  0.12Diluted
                      (A/C)
                  
                  
                  0.12
                  
                  
                  
                  0.05
                  
                  
                  
                  0.20
                  
                  
                  
                  0.11
 
 The
            Company’s calculation of diluted net income per share for the three months ended
            June 30, 2007 and 2006 excludes stock options to purchase approximately
            741,000
            and 366,000 shares of the Company’s common stock, respectively, and diluted net
            income per share for the six months ended June 30, 2007 and 2006, excludes
            stock
            options to purchase approximately 577,000 and 417,000 shares of the Company’s
            common stock, respectively, as their effect would be antidilutive.
 
 **4.**
                  **STOCK-BASED
                      COMPENSATION**
 
 The
            Company’s Stock Option Plans, adopted in 1995, 1999 and 2006, authorize the
            Board of Directors or the Compensation Committee, as applicable, to grant
            incentive and nonqualified stock options, and, in the case of the 2006
            Equity
            Incentive Plan (the “2006 Plan”), stock appreciation rights, restricted stock,
            restricted stock units, performance shares, performance units and other
            stock-based awards. After adoption of the 2006 Plan, the Company may
            no longer
            issue grants from previous plans, but any shares subject to awards under
            the
            1999 Stock Option and Incentive Plan and the Outside Directors Stock
            Option Plan
            (collectively, the “1999 Plans”) that are cancelled will be added to shares
            available under the 2006 Plan. A maximum of 4,950,933 shares are available
            for
            delivery under the 2006 Plan, which consists of (i) 1,250,000 shares,
            plus (ii)
            320,000 shares available for issuance under the 1999 Plans, but not underlying
            any outstanding stock options or other awards under the 1999 Plans, plus
            (iii)
            up to 3,380,933 shares subject to outstanding stock options or other
            awards
            under the 1999 Plans that expire, are forfeited or otherwise terminate
            unexercised on or after adoption of the 2006 Plan. The number of shares
            available under the 2006 Plan is subject to adjustment for certain changes
            in
            the Company’s capital structure. The exercise price of options granted under the
            2006 Plan is equal to the closing price of the Company’s common stock, as
            reported by The NASDAQ Global Market, on the last trading day prior to
            the date
            of grant.
 
 Prior
            to
            2007, options were granted based on historical performance after the
            Company’s
            quarterly and/or annual results were known, and generally vested in equal
            annual
            installments over four years from the first anniversary of the date of
            grant. In
            fiscal 2007, the Company began granting stock options as of the beginning
            of the
            year. Stock option grants are now categorized into two groups: (1) executive
            officer grants and (2) non-executive officer and director
            grants.  Stock options granted to non-executive officers and directors
            are subject only to time vesting.  The fair value of these
            non-executive officer and director option grants is determined on the
            date of
            grant and the related compensation expense is recognized for the entire
            award on
            a straight-line basis over the vesting period.  Stock options granted
            to executive officers are subject to cancellation if specified performance
            targets for fiscal 2007 (as defined in the executives’ 2007 compensation plans)
            are not achieved.  If the applicable performance targets are achieved,
            the options will vest in four equal installments on each of January 1,
            2009,
            2010, 2011 and 2012.  The fair value of the executive officer option
            grants is determined on the date of grant and the related compensation
            expense  is recognized over the requisite service period, including
            the initial period for which the performance targets must be met, for
            each
            separately vesting portion of the award as if each vesting tranche was
            a
            separate award.  The valuation assumptions used for each method are
            similar, although tailored for each vesting tranche of the awards for
            the
            executive officer grants.
 
  -
                10
                -
 **-
                back to table of contents -**
  **Interactive
            Intelligence, Inc.**
 **Notes
            to Condensed Consolidated Financial Statements (continued)**
 
 For
            most
            options granted through December 31, 2004, the term of each option is
            ten years
            from the date of grant. In 2005, the Company began issuing options with
            a term
            of six years from the date of grant.
 
 If
            an
            incentive stock option is granted to an employee who, at the time the
            option is
            granted, owns stock representing more than ten percent of the voting
            power of
            all classes of stock of the Company, the exercise price of the option
            may not be
            less than 110% of the market value per share on the date the option is
            granted
            and the term of the option shall be not more than five years from the
            date of
            grant.
 
 The
            plans
            may be terminated by the Board of Directors at any time.
 
 *Expense
            Information under SFAS 123R*
 
 The
            following table summarizes the allocation of stock-based compensation
            expense
            related to employee stock options under SFAS 123R for the three and six
            months
            ended June 30, 2007 and 2006 (in thousands, except per share
            amounts):
 
 **Three
                        Months Ended**
                      **June
                        30,**
                  
                  
                  **Six
                        Months Ended**
                      **June
                        30,****2007**
                  
                  
                  **2006**
                  
                  
                  **2007**
                  
                  
                  **2006**Stock-based
                      compensation expense for employee stock options by
                      category:Cost
                      of services
                  
                  $
                  68
                  
                  
                  $
                  39
                  
                  
                  $
                  114
                  
                  
                  $
                  78Sales
                      and marketing
                  
                  
                  330
                  
                  
                  
                  264
                  
                  
                  
                  630
                  
                  
                  
                  549Research
                      and development
                  
                  
                  158
                  
                  
                  
                  61
                  
                  
                  
                  258
                  
                  
                  
                  110General
                      and administrative
                  
                  
                  250
                  
                  
                  
                  304
                  
                  
                  
                  472
                  
                  
                  
                  420Total
                      stock-based compensation expense for employee stock
                      options
                  
                  $
                  806
                  
                  
                  $
                  668
                  
                  
                  $
                  1,474
                  
                  
                  $
                  1,157Effect
                      of stock-based compensation for employee stock options on net
                      income per
                      share:Basic
                  
                  $
                  (0.05
                  )
                  
                  $
                  (0.04
                  )
                  
                  $
                  (0.08
                  )
                  
                  $
                  (0.07
                  )Diluted
                  
                  $
                  (0.04
                  )
                  
                  $
                  (0.04
                  )
                  
                  $
                  (0.08
                  )
                  
                  $
                  (0.07
                  )
 
 **5.**
                  **CONCENTRATION
                      OF CREDIT RISK**
 
 No
            customer or partner represented a greater than 10% concentration of the
            Company’s accounts receivable as of June 30, 2007 or December 31, 2006. In
            addition, no customer or partner had greater than 10% concentration of
            the
            Company’s revenues for the three and six months ended June 30, 2007 and
            2006.
 
 **6.**
                  **COMMITMENTS
                      AND CONTIGENCIES**
 
 *Legal
            Proceedings*
 
 From
            time
            to time, the Company has received notification from competitors and other
            technology providers claiming that the Company’s technology infringes their
            proprietary rights. The Company cannot assure you that these matters
            can be
            resolved amicably without litigation, or that the Company will be able
            to enter
            into licensing arrangements on terms and conditions that would not have
            a
            material adverse effect on its business, financial condition or results
            of
            operations.
 
 In
            November 2002, the Company received a notification from the French government
            as
            a result of a tax audit that had been conducted encompassing the years
            1998,
            1999, 2000 and 2001. In December 2005, the Company received an additional
            notification from the French government as a result of an updated tax
            audit that
            they conducted. Both of 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. In May 2007, the French court ruled
            against
            the Company on the first notification and declared the amounts due ($3.2
            million
            for VAT and $316,000 for corporation taxes). As of June 30, 2007, the
            assessment
            related to VAT was approximately $5.8 million and the assessment related
            to
            corporation taxes was approximately $688,000.  As of June 30, 2007,
            the Company has recorded what it deems an appropriate amount for the
            corporate
            tax assessment. No accrual has been made by the Company with respect
            to the VAT
            assessment.
 
 
  -
                11
                -
 **-
                back to table of contents -**
  **Interactive
            Intelligence, Inc.**
 **Notes
            to Condensed Consolidated Financial Statements (continued)**
  Based
            on
            discussions between the Company and its tax counsel and advisors, the
            Company
            determined that no additional accruals are necessary.  Because the
            judgment from the French court was against Interactive Intelligence France
            S.A.R.L. (the “SARL”), a wholly owned subsidiary of the Company, it does not
            believe that the French government can impose the liability on Interactive
            Intelligence, Inc. and the SARL does not have any significant assets
            with which
            to pay.  In addition, the Company’s tax counsel and advisors still
            contend that the case is without merit and the Company has two more appeal
            routes, which could take up to ten years to resolve.
 
 The
            Company has filed for VAT refunds in France of more than $600,000, which
            the
            Company has not recorded as a receivable and to which the French government
            has
            not yet responded. The Company believes that these VAT refunds could
            be used to
            offset amounts owed to the French government in connection with the assessments,
            if necessary.  Although the Company is appealing both the VAT and
            corporation tax assessments, it cannot assure you that these matters
            will be
            resolved without further litigation or that it will not have to pay some
            or all
            of the assessments.
 
 From
            time
            to time, the Company is also involved in certain legal proceedings in
            the
            ordinary course of conducting its business. While the ultimate liability
            pursuant to these actions cannot currently be determined, the Company
            believes
            these legal proceedings will not have a material adverse effect on its
            financial
            position or results of operations. Litigation in general, and intellectual
            property litigation in particular, can be expensive and disruptive to
            normal
            business operations. Moreover, the results of complex legal proceedings
            are
            difficult to predict.
 
 *Lease
            Commitments*
 
 On
              June
              19, 2007, the Company entered into an amendment of its corporate office
              operating lease under which the leased space will be expanded by approximately
              79,385 rentable square feet in an office building currently under construction
              and adjacent to the Company’s corporate headquarters. The rent for the
              additional space through the lease expiration date (March 31, 2018)
              will be
              approximately $16.3 million, payable in pro-rata monthly installments
              through
              the lease term, as defined in the amendment. Rent payments will commence
              as the
              Company utilizes the additional space, which is expected to be no earlier
              than
              March 1, 2008 and as a result, there was no financial statement impact
              for the
              three months ended June 30, 2007.  In consideration for entering into
              the amendment, the landlord agreed to pay the Company a discretionary
              allowance
              of $450,000 which is payable as the Company utilizes the additional
              space in the
              office building. The Company will use the allowance for certain costs
              associated
              with the Company’s corporate headquarters and/or the additional space, as
              defined in the amendment.
 
 *Other
            Contingencies*
 
 The
            Company has received and may continue to receive certain payroll tax
            credits and
            real estate tax abatements that were granted to the Company based upon
            certain
            growth projections.  If the Company’s actual results are less than those
            projections, the Company may be subject to repayment of some or all of the
            payroll tax credits or payment of additional real estate taxes in the
            case of
            the abatements.  The Company does not believe that it will be subject to
            payment of any money related to these taxes, however the Company cannot
            provide
            assurance as to the outcome.
 
 **7.**
                  **INCOME
                      TAXES**
 
 The
            Company recorded its income taxes in accordance with SFAS 109. Management
            considers, when assessing the realizability of deferred tax assets, whether
            it
            is more likely than not that some portion or all of the deferred tax
            assets will
            not be realized. The ultimate realization of deferred tax assets is dependent
            upon the generation of future taxable income during the periods in which
            those
            temporary differences become deductible. Management considers the scheduled
            reversal of deferred tax liabilities, if any, projected future taxable
            income,
            and tax planning strategies in making this assessment.
 
  -
                12
                -
 **-
                back to table of contents -**
  **Interactive
            Intelligence, Inc.**
 **Notes
            to Condensed Consolidated Financial Statements (continued)**
 
 The
            Company had $44.1 million of tax net operating loss carry-forwards and
            $4.7
            million in tax credit carry-forwards at December 31, 2006. Included in
            the net
            operating loss carry-forwards was $8.7 million related to disqualifying
            dispositions of stock options. The tax benefit of the disqualifying tax
            dispositions deductions, if realized for financial reporting purposes,
            will be
            recorded as a credit to additional paid-in capital.
 
 The
            Company recorded an income tax benefit of $5.0 million during the third
            quarter
            of 2006 to reduce the valuation allowance for its deferred tax assets.
            The
            Company had a valuation allowance of $20.9 million at December 31, 2006.
            Management will continue to evaluate the recoverability of the deferred
            tax
            assets on a quarterly basis.
 
 Effective
            January 1, 2007, the Company adopted FASB Interpretation No. 48, *Accounting
            for Uncertainty in Income Taxes an interpretation of FASB Statement No.
            109*
            (“FIN 48”).  FIN 48 prescribes a recognition threshold and measurement
            attributes for the financial statement recognition and measurement of
            a tax
            position taken or expected to be taken in a tax return.  Adoption of
            FIN 48 had no impact on the Company's consolidated results of operations
            and
            financial position.
 
 Upon
            adoption of FIN 48, the Company identified an uncertain tax position
            related to
            certain tax credits that the Company currently believes may not meet
            the “more
            likely than not” recognition threshold under FIN 48 to be sustained upon
            examination. Since this uncertain tax position has not been utilized
            and had a
            full valuation allowance established, the effect would be to reduce the
            gross
            deferred tax asset and valuation allowance by $4.7 million. This amount
            relates
            to unrecognized tax benefits that would impact the effective tax rate
            if
            recognized absent the valuation allowance. The Company and its subsidiaries
            file
            income tax returns in the U.S. federal jurisdiction, and various states
and
            foreign jurisdictions.  Tax years 2003 and forward remain open for
            examination for federal tax purposes and tax years 2002 and forward remain
            open
            for examination for the Company’s more significant state tax
            jurisdictions.   To the extent utilized in future years’ tax
            returns, net operating loss and capital loss carry forwards at June 30,
            2007
            will remain subject to examination until the respective tax year is
            closed.
 
 **8.**
                  **ACQUISITION**
 
 *Asset
            Purchase Agreement*
 
 On
            April
            17, 2007, the Company entered into an asset purchase agreement, dated
            as of the
            same date, with Alliance Systems Ltd. (“Alliance”), a partner of the Company
            that provides computer infrastructure such as server and storage solutions
            that
            supports wireless, VoIP, contact center, security, and video enterprise
            communications solutions. Pursuant to the asset purchase agreement, the
            Company
            acquired the professional services division of Alliance which was focused
            on
            licensing, implementing and supporting the Company’s contact center automation
            and enterprise IP telephony software solutions, for an aggregate purchase
            price
            of $1.1 million, less adjustment for certain costs and pro-rated customer
            receipts. A total of 13 professional services engineers and one sales
            representative joined the Company in connection with the acquisition.
            The
            Company funded $853,000 of the purchase price with cash available from
            operations. A hold back provision for $180,000 was paid to Alliance subsequent
            to June 30, 2007, upon achievement of certain conditions as specified
            in the
            asset purchase agreement.
 
 The
              purchase price allocations for the Company’s acquisition of the professional
              services division of Alliance are based on a third-party valuation
              report which
              was prepared in accordance with the provisions of SFAS No. 141, *Business
              Combinations* and are subject to adjustment. The following table
              summarizes the fair value of the intangible and other assets acquired
              and
              liabilities assumed at the date of acquisition (in
              thousands):
 
 **April
                        17, 2007**Goodwill
                  
                  $
                  996Customer
                      relationships
                  
                  
                  50Fixed
                      assets
                  
                  
                  36Total
                      assets acquired
                  
                  $
                  1,082Deferred
                      services revenue
                  
                  
                  (49
                  )Net
                      assets acquired
                  
                  $
                  1,033
 
 The
            premium paid over the fair value of the net assets acquired in the purchase,
            or
            goodwill, was primarily attributed to expected synergies from the Company’s
            acquisition of a professional services team having prior experience with
            the
            Company’s solutions and their implementation.
  -
                13
                -
 **-
                back to table of contents -**
  **Interactive
            Intelligence, Inc.**
 **Notes
            to Condensed Consolidated Financial Statements (continued)**
 
 *Goodwill*
 
 As
            a
            result of recording goodwill related to the acquisition discussed above,
            goodwill will be reviewed for impairment at least annually in accordance
            with
            the provisions of SFAS No. 142, *Goodwill and Other Intangible
            Assets*. The goodwill impairment test is a two-step test. Under the first
            step, the fair value of the reporting unit is compared with its carrying
            value
            (including goodwill). If the fair value of the reporting unit is less
            than its
            carrying value, an indication of goodwill impairment exists for the reporting
            unit and the enterprise must perform step two of the impairment test
            (measurement). Under step two, an impairment charge is recognized for
            any excess
            of the carrying amount of the reporting unit’s goodwill over the implied fair
            value of that goodwill. The implied fair value of goodwill is determined
            by
            allocating the fair value of the reporting unit in a manner similar to
            a
            purchase price allocation, in accordance with SFAS No. 141, *Business
            Combinations*. The residual fair value after this allocation is the implied
            fair value of the reporting unit goodwill. Fair value of the reporting
            unit is
            determined using a discounted cash flow analysis. If the fair value of
            the
            reporting unit exceeds its carrying value, step two does not need to
            be
            performed. For purposes of the impairment test, the assembled workforce
            is
            considered a reporting unit. The Company plans to perform an annual impairment
            test on the recorded amount.
 
 **9.**
                  **RECENT
                      ACCOUNTING PRONOUNCEMENTS**
 
 In
            February 2007, the FASB issued SFAS No. 159, *The Fair Value Option for
            Financial Assets and Financial Liabilities - Including an amendment of
            SFAS No.
            115*, *Accounting for Certain Investments in Debt and Equity
            Securities* (“SFAS 159”). SFAS 159 permits entities to choose to measure
            many financial assets and financial liabilities at fair value. Unrealized
            gains
            and losses on items for which the fair value option has been elected
            are
            reported in earnings. SFAS 159 is effective for the fiscal year beginning
            January 1, 2008.  The Company is currently evaluating the impact, if
            any, of the adoption of SFAS 159. The Company does not expect the adoption
            of
            SFAS 159 will have a material impact on its consolidated financial position,
            results of operations or cash flows.
 
 In
            September 2006, the FASB issued SFAS No. 157, *Fair Value Measurements*(“SFAS 157”). SFAS 157 defines fair value, establishes a framework for
            measuring fair value in generally accepted accounting principles and
            expands
            disclosures about fair value measurements. This Statement applies to
            previous
            accounting pronouncements that require or permit fair value measurements.
            Accordingly, this Statement does not require any new fair value measurements.
            SFAS 157 is effective for the fiscal year beginning January 1, 2008.
            The Company
            is currently evaluating the impact, if any, of the adoption of SFAS 157.
            The
            Company does not expect the adoption of SFAS 157 will have a material
            impact on
            its consolidated financial position, results of operations or cash
            flows.
  -
                14
                -
 **-
                back to table of contents -**
 
 **Item
                      2.**
                  **Management’s
                      Discussion and Analysis of Financial Condition and
                      Results of Operations.**
 
 The
            following Management’s Discussion and Analysis of Financial Condition and
            Results of Operations is intended to provide investors with an understanding
            of
            the Company’s past performance, its financial condition and its prospects and
            should be read in conjunction with other sections of this Quarterly Report
            on
            Form 10-Q. Investors should carefully review the information contained
            in this
            report under Part II, Item 1A “Risk Factors” and in the Item 1A “Risk Factors”
section of our Annual Report on Form 10-K for the fiscal year ended December
            31,
            2006. The following will be discussed and analyzed:
  ·      Forward-Looking
            Information
 
 ·      Overview
            Business Strategy
 
 ·      Financial
            Highlights
 
 ·      Historical
            Results of Operations
 
 ·      Liquidity
            and Capital Resources
 
 ·      Critical
            Accounting Policies and Estimates
 
 **Forward-Looking
            Information**
 
 Certain
            statements in this Quarterly Report on Form 10-Q contain “forward-looking”
information (as defined in the Private Securities Litigation Reform Act
            of
            1995,Section
            27A
            of the Securities Act of 1933, as amended and Section 21E of the Securities
            Exchange Act of 1934, as amended) that involves risks and uncertainties
            which
            may cause actual results to differ materially from those predicted in
            the
            forward-looking statements. Forward-looking statements can often be identified
            by their use of such verbs as “expects”, “anticipates”, “believes”, “intend”,
“plan”, “may”, “should”, “will”, “would”, “will be”, “will continue”, “will
            likely result”, or similar verbs or conjugations of such verbs. If any of our
            assumptions on which the statements are based prove incorrect or should
            unanticipated circumstances arise, our actual results could materially
            differ
            from those anticipated by such forward-looking statements. The differences
            could
            be caused by a number of factors or combination of factors, including,
            but not
            limited to, rapid technological changes in the industry; our ability
            to maintain
            profitability, to manage successfully our growth and increasingly complex
            third
            party relationships, to maintain successful relationships with our current
            and
            any new partners, to maintain and improve our current products and to
            develop
            new products and to protect our proprietary rights adequately; and other
            factors
            set forth in our Securities and Exchange Commission (“SEC”) filings, including
            the Item 1A “Risk Factors” section of our Annual Report on Form 10-K for the
            fiscal year ended December 31, 2006.
  **Overview**
 
 Interactive
            Intelligence, Inc. (“Interactive Intelligence”, “we”, “us” or “our”) was formed
            in 1994 as an Indiana corporation and maintains its world headquarters
            and
            executive offices at 7601 Interactive Way, Indianapolis, IN 46278. Our
            telephone
            number is (317) 872-3000. We are located on the Web at
*http://www.inin.com*. Our periodic and current reports and all
            amendments to those reports required to be filed or furnished pursuant
            to
            Section 13(a) or 15(d) of the Securities Exchange Act of 1934 are available
            free
            of charge through our investor relations page located on our Website
            at
*http://www.inin.com**/investors*.
 
 We
            are a
            leading provider of software applications for contact centers and we
            are
            leveraging that leadership position to provide mission critical voice
            over
            Internet protocol (“VoIP”) applications to enterprises. Our solutions are
            utilized in contact centers of teleservices firms, international corporations,
            public agencies, telecommunications companies, distributed organizations,
            government and commercial enterprises, and increasingly for the remote
            and
            mobile workforce. We also offer the only pre-integrated all-software
            Internet
            Protocol Private Branch Exchange (“IP PBX”), a phone and communications solution
            for mid-sized enterprises that relies on the Microsoft Corporation (“Microsoft”)
            platform. We offer innovative software products and services for multi-channel
            contact management, business communications, messaging and session initiation
            protocol (“SIP”)-supported VoIP.
 
  -
                15
                -
 **-
                back to table of contents -**
  Our
            application-based solutions are integrated on a platform that scales
            to
            thousands of users, and are developed to satisfy today’s diverse interaction
            needs in markets for:
 
 ·
                  Contact
                      Centers
 
 ·
                  Enterprise
                      IP Telephony
 
 ·
                  Enterprise
                      Messaging
 
 ·
                  Self-Service
                      Automation
 
 By
            implementing our all-in-one solutions, businesses are able to unify
            communications, enhance workforce effectiveness and productivity, and
            readily
            adapt to constantly changing market and customer requirements. Moreover,
            organizations are able to reduce the cost and complexity of traditional
            “multi-point” legacy communications hardware systems that are seldom fully
            integrated.
 
 **Financial
            Highlights**
 
 For
            the
            three months ended June 30, 2007, revenues grew 12% over the previous
            three
            month period and 40% over the three months ended June 30, 2006. Factors
            that affect orders in any particular quarter include potential customers’ budget
            constraints, personnel resources to implement our solutions, historical
            product
            order patterns and willingness to implement a critical telecommunications
            system. As the table below shows, revenues in any particular quarter
            can greatly
            fluctuate from other periods. Because the terms of a contract or prior
            payment
            experience with a customer or partner affect revenue recognition, revenue
            recognition may occur in a period later than when an order is
            received.
 
 The
            information below shows our total revenues (in millions) for the most
            recent
            five quarters and the years ended December 31, 2006, 2005 and 2004 and the
            percentage change over the previous period.
 
 **Period**
                  
                  **Revenues**
                  
                  
                  **%
                      Growth**Three
                      months ended:June
                      30, 2007
                  
                  $
                  27.0
                  
                  
                  
                  12
                  %March
                      31, 2007
                  
                  
                  24.2
                  
                  
                  
                  1December
                      31, 2006
                  
                  
                  23.9
                  
                  
                  
                  8September
                      30, 2006
                  
                  
                  22.2
                  
                  
                  
                  15June
                      30, 2006
                  
                  
                  19.3
                  
                  
                  
                  8Year
                      ended December 31:2006
                  
                  $
                  83.2
                  
                  
                  
                  32
                  %2005
                  
                  
                  62.9
                  
                  
                  
                  142004
                  
                  
                  55.1
                  
                  
                  
                  7
 
 Although
            revenues can fluctuate from quarter to quarter, we have experienced increasing
            annual revenue growth in part due to an increase in the dollar value
            of orders
            we received for our contact center and IP PBX solutions. We also attribute
            annual revenue growth to a number of other factors including but not
            limited to:
            adoption of VoIP technologies by our customers; increasing market awareness
            of
            our solutions; improvements in scalability and the reliability of our
            products;
            reductions in hardware costs to deploy our solutions making our solutions
            more
            financially attractive to customers; changes in our sales program to
            target new
            customers; and establishment of an inside sales group to work with current
            customers.  We did not experience any significant shifts during the
            three and six months ended June 30, 2007, compared to the same periods
            in 2006,
            in geographic distribution or percentage of orders from new
            customers.
 
 Services
            revenues increased significantly during the three and six months ended
            June 30,
            2007, compared to the same periods in 2006, primarily due to additional
            support
            fees and annually renewable license fees, which were recognized for our
            growing
            installed customer base, and an increase in revenues from professional
            services
            as more of our larger, direct customers utilized our professional services
            group
            to assist in installing our solutions.
 
 Our
            costs
            of products continue to increase due to additional hardware costs and
            increased
            royalty expenses as a result of licensing more third party software as
            part of
            the orders received.  Costs of services and operating expenses for the
            three and six months ended June 30, 2007 increased significantly compared
            to the
            same periods in 2006 primarily due to a 30% increase in company-wide
            staffing at
            June 30, 2007 compared to June 30, 2006 and related costs.
  -
                16
                -
 **-
                back to table of contents -**
 
 In
            January 2006, we implemented SFAS 123R and began incurring expenses each
            quarter
            as stock options were granted and vested.  The following is a summary
            of those expenses for the three and six months ended June 30, 2007 and
            2006 (in
            thousands, except per share amounts):
 
 **Three
                        Months**
                      **Ended
                        June 30,**
                  
                  
                  **Six
                        Months**
                      **Ended
                        June 30,****2007**
                  
                  
                  **2006**
                  
                  
                  **2007**
                  
                  
                  **2006**Total
                      stock-based compensation expense for employee stock
                      options
                  
                  $
                  806
                  
                  
                  $
                  668
                  
                  
                  $
                  1,474
                  
                  
                  $
                  1,157Effect
                      of stock-based compensation for employee stock options on net
                      income per
                      share:Basic
                  
                  $
                  (0.05
                  )
                  
                  $
                  (0.04
                  )
                  
                  $
                  (0.08
                  )
                  
                  $
                  (0.07
                  )Diluted
                  
                  $
                  (0.04
                  )
                  
                  $
                  (0.04
                  )
                  
                  $
                  (0.08
                  )
                  
                  $
                  (0.07
                  )
 
 Based
            on
            currently issued non-vested options as of June 30, 2007, we expect expenses
            related to SFAS 123R to be approximately $1.6 million for the remainder
            of
            2007.
 
 In
            April
            2007, pursuant to an asset purchase agreement, we acquired certain intangible
            and other assets and assumed certain liabilities of the professional
            services
            division of Alliance. A total of 13 professional services engineers and
            one
            sales representative joined our company as a result of the acquisition.
            These
            individuals possessed previous experience with our solutions and their
            implementation, as Alliance was already one of our established partners.
            We
            funded $853,000 of the purchase price with cash available from operations.
            The
            purchase price also included a hold back provision of $180,000 to cover
            costs
            for training and recruiting if any of the acquired Alliance employees
            left our
            company within 90 days after closing the transaction.  The hold back
            was paid in full in July 2007. This acquisition has enabled us to immediately
            expand our professional services group in an effort to more effectively
            support
            our customers. See Note 8 of Notes to Condensed Consolidated Financial
            Statements for further information.
 
 **Historical
            Results of Operations**
 
 The
            following table presents certain financial data, derived from our unaudited
            statements of income, as a percentage of total revenues for the periods
            indicated. The operating results for the three and six months ended June
            30,
            2007 and 2006 are not necessarily indicative of the results that may
            be expected
            for the full year or for any future period.
 
 **Three
                        Months Ended**
                      **June
                        30,**
                  
                  
                  **Six
                        Months Ended**
                      **June
                        30,****2007**
                  
                  
                  **2006**
                  
                  
                  **2007**
                  
                  
                  **2006**Revenues:Product
                  
                  
                  54
                  %
                  
                  
                  50
                  %
                  
                  
                  52
                  %
                  
                  
                  50
                  %Services
                  
                  
                  46
                  
                  
                  
                  50
                  
                  
                  
                  48
                  
                  
                  
                  50Total
                      revenues
                  
                  
                  100
                  
                  
                  
                  100
                  
                  
                  
                  100
                  
                  
                  
                  100Cost
                      of revenues:Product
                  
                  
                  13
                  
                  
                  
                  11
                  
                  
                  
                  11
                  
                  
                  
                  9Services
                  
                  
                  19
                  
                  
                  
                  17
                  
                  
                  
                  20
                  
                  
                  
                  18Total
                      cost of revenues
                  
                  
                  32
                  
                  
                  
                  28
                  
                  
                  
                  31
                  
                  
                  
                  27Gross
                      profit
                  
                  
                  68
                  
                  
                  
                  72
                  
                  
                  
                  69
                  
                  
                  
                  73Operating
                      expenses:Sales
                      and marketing
                  
                  
                  33
                  
                  
                  
                  35
                  
                  
                  
                  34
                  
                  
                  
                  37Research
                      and development
                  
                  
                  16
                  
                  
                  
                  17
                  
                  
                  
                  16
                  
                  
                  
                  17General
                      and administrative
                  
                  
                  12
                  
                  
                  
                  15
                  
                  
                  
                  12
                  
                  
                  
                  14Total
                      operating expenses
                  
                  
                  61
                  
                  
                  
                  67
                  
                  
                  
                  62
                  
                  
                  
                  68Operating
                      income
                  
                  
                  7
                  
                  
                  
                  5
                  
                  
                  
                  7
                  
                  
                  
                  5Other
                      income (expense):Interest
                      income, net
                  
                  
                  1
                  
                  
                  
                  1
                  
                  
                  
                  1
                  
                  
                  
                  1Other
                      income (expense)
                  
                  
                  --
                  
                  
                  
                  --
                  
                  
                  
                  --
                  
                  
                  
                  --Total
                      other income (expense)
                  
                  
                  1
                  
                  
                  
                  1
                  
                  
                  
                  1
                  
                  
                  
                  1Income
                      before income taxes
                  
                  
                  8
                  
                  
                  
                  6
                  
                  
                  
                  8
                  
                  
                  
                  6Income
                      tax expense
                  
                  
                  --
                  
                  
                  
                  (1
                  )
                  
                  
                  --
                  
                  
                  
                  (1
                  )Net
                      income
                  
                  
                  8
                  %
                  
                  
                  5
                  %
                  
                  
                  8
                  %
                  
                  
                  5
                  %
 
  -
                17
                -
 **-
                back to table of contents -**
  **Comparison
            of Three and Six Months Ended June 30, 2007 and 2006**
 
 ***Revenues***
 
 *Product
            Revenues*
 **Three
                        Months Ended**
                      **June
                        30,**
                  
                  
                  **Six
                        Months Ended**
                      **June
                        30,****2007**
                  
                  
                  **2006**
                  
                  
                  **2007**
                  
                  
                  **2006****($
                      in thousands)**Product
                      revenues
                  
                  $
                  14,447
                  
                  
                  $
                  9,586
                  
                  
                  $
                  26,708
                  
                  
                  $
                  18,447Change
                      from prior year period
                  
                  
                  51
                  %
                  
                  
                  12
                  %
                  
                  
                  45
                  %
                  
                  
                  12
                  %Percentage
                      of total revenues
                  
                  
                  54
                  %
                  
                  
                  50
                  %
                  
                  
                  52
                  %
                  
                  
                  50
                  %
 
 Product
            revenues, which include software and hardware, can fluctuate from quarter
            to
            quarter depending on several factors including the mix of orders between
            perpetual licenses and annually renewable licenses. The increase in product
            revenues during the three and six months ended June 30, 2007 compared
            to the
            same periods in 2006 was due primarily to higher dollar amounts of orders
            that
            we received.  The dollar value of orders received in the three and six
            months ended June 30, 2007 increased approximately 58% and 40%, respectively,
            from the same periods in 2006.  Perpetual orders during the three and
            six months ended June 30, 2007 accounted for 83% and 81%, respectively,
            of
            product orders compared to 73% and 72% during the same periods in
            2006.  If other revenue recognition criteria are satisfied, we
            recognize license revenue upfront for perpetual licenses, and we recognize
            revenue for annually renewable licenses ratably over the term. The impact
            of the
            mix of contracts on our product revenues occurs only in the initial year
            of an
            order; subsequent renewal fees received for the annually renewable licenses
            and
            the renewal support fees for perpetual contracts are all allocated entirely
            to
            services revenues.
 
 The
            amount of orders we receive, while impacting products revenues, does
            not have an
            exact correlation to revenues because the terms in the contracts, collection
            history with the customer or partner, and any other contractual conditions
            affect whether we can recognize the order during the quarter or in subsequent
            quarters.  Consequently, product revenues for any particular quarter
            are impacted not only by orders received in the current quarter but also
            by
            orders received in previous quarters that are being recognized in the
            current
            quarter.
 
 
 *Services
            Revenues*
 **Three
                        Months Ended**
                      **June
                        30,**
                  
                  
                  **Six
                        Months Ended**
                      **June
                        30,****2007**
                  
                  
                  **2006**
                  
                  
                  **2007**
                  
                  
                  **2006****($
                      in thousands)**Services
                      revenues
                  
                  $
                  12,533
                  
                  
                  $
                  9,667
                  
                  
                  $
                  24,465
                  
                  
                  $
                  18,736Change
                      from prior year period
                  
                  
                  30
                  %
                  
                  
                  38
                  %
                  
                  
                  31
                  %
                  
                  
                  36
                  %Percentage
                      of total revenues
                  
                  
                  46
                  %
                  
                  
                  50
                  %
                  
                  
                  48
                  %
                  
                  
                  50
                  %
 
 Services
            revenues include the portion
            of the initial license arrangement allocated to services revenues from
            annually
            renewable and perpetual contracts, license renewals of annually renewable
            contracts, and support fees for perpetual contracts, as well as professional
            services, education and other miscellaneous revenues.
 
 The
            increase during the three and six months ended June 30, 2007 compared
            to the
            same periods in 2006 was primarily due to our growing installed base
            of
            customers and related payments of annual license renewal fees and support
            fees
            for perpetual licenses. License renewal and support revenues generated
            incremental revenues of $1.7 million and $3.1 million during the three
            and six
            months ended June 30, 2007, respectively, compared to the same periods
            in 2006.
            As new customers license our solutions, we expect that our services revenues
            will increase as these customers continue to renew their licenses and
            pay for
            ongoing support for our solutions.  The actual percentage fee charged
            for renewal of annually renewable licenses and perpetual support agreements
            as
            compared to the initial annually renewable license fee and perpetual
            license,
            respectively, is comparable on a relative percentage basis, and therefore,
            the
            mix of these types of contracts in the future is not expected to impact
            our
            future services revenues.
 
 During
            the three and six months ended June 30, 2007, revenues from professional
            services increased $1.1 million and $2.3 million, respectively, from
            the same
            periods in 2006 due to more of our larger, direct customers utilizing
            our
            professional services group to assist in installing our solutions.  In
            the first quarter of 2007, we utilized third party resources to assist
            with the
            demand for professional services.  In April 2007, we acquired the
            professional services division of Alliance, which added 13 professionals
            to our
            group and increased our resources to serve our customers. We anticipate
            these
            revenues will continue to increase in 2007 as the number of our large,
            direct
            customers continues to grow.
 
  -
                18
                -
 **-
                back to table of contents -**
  Educational
            and other services are also included in services revenues and were $1.0
            million
            and $2.2 million for the three and six months ended June 30, 2007, respectively,
            compared to $1.0 million and $1.8 million during the same periods in
            2006. These
            revenues have and will fluctuate based on the number of customers and
            partners
            that attend our educational classes, the amount of assistance our customers
            and
            partners need for implementation and installation and commissions that
            we
            receive on hardware sold to our end customers by a third party.
  ***Cost
            of
            Revenues***
 **Three
                        Months Ended**
                      **June
                        30,**
                  
                  
                  **Six
                        Months Ended**
                      **June
                        30,****2007**
                  
                  
                  **2006**
                  
                  
                  **2007**
                  
                  
                  **2006****($
                      in thousands)**Cost
                      of revenues:Product
                  
                  $
                  3,500
                  
                  
                  $
                  2,033
                  
                  
                  $
                  5,941
                  
                  
                  $
                  3,366Services
                  
                  
                  5,245
                  
                  
                  
                  3,244
                  
                  
                  
                  10,042
                  
                  
                  
                  6,307Total
                      cost of revenues
                  
                  $
                  8,745
                  
                  
                  $
                  5,277
                  
                  
                  $
                  15,983
                  
                  
                  $
                  9,673Change
                      from prior year period
                  
                  
                  66
                  %
                  
                  
                  38
                  %
                  
                  
                  65
                  %
                  
                  
                  33
                  %Product
                      costs as a % of product revenues
                  
                  
                  24
                  %
                  
                  
                  21
                  %
                  
                  
                  22
                  %
                  
                  
                  18
                  %Services
                      costs as a % of services revenues
                  
                  
                  42
                  %
                  
                  
                  34
                  %
                  
                  
                  41
                  %
                  
                  
                  34
                  %
 
 Costs
            of product consist of hardware
            costs, principally for servers, telephone handsets and gateways, royalties
            for
            software we distribute, royalties for technologies included in our solutions
            and, to a lesser extent, software packaging costs, which include product
            media,
            duplication and documentation. Costs of product can fluctuate depending
            on which
            software applications are licensed to our customers, the third party
            software,
            if any, which is licensed by the end user from us as part of our software
            applications and the dollar amount of orders for hardware.
 
 Costs
            of
            product increased $1.5 million or 72% and $2.6 million or 77% during
            the three
            and six months ended June 30, 2007, respectively, compared to the same
            periods
            in 2006. Hardware costs represented $714,000 and $1.1 million of the
            increase during the three and six months ended June 30, 2007, respectively,
            compared to the same periods in 2006.  Royalties paid to third parties
            increased $544,000 and $1.2 million during the three and six months ended
            June
            30, 2007, respectively, compared to the same periods in 2006, as we licensed
            more third party software as part of orders received. In addition, we
            also
            increased staffing in our distribution center during 2007 compared to
            2006 which
            resulted in $124,000 and $196,000 of incremental compensation for the
            three and
            six months ended June 30, 2007, respectively. The remaining increases
            were
            related to miscellaneous expenses.
 
 Costs
            of
            services consist primarily of compensation expenses for technical support,
            educational and professional services personnel and other costs associated
            with
            supporting our partners and customers. These expenses increased during
            the three
            and six months ended June 30, 2007, as compared to the same periods in
            2006,
            primarily due to a $1.5 million and $2.5 million increase in compensation
            expense, respectively, as a result of a 41% increase in our services
            staffing at
            June 30, 2007 compared to June 30, 2006. As a result of the increased
            professional services activity, travel related expenses increased $154,000
            and
            $223,000 for the three and six months ended June 30, 2007, respectively,
            compared to the same periods in 2006.  In the first quarter of 2007,
            we experienced more demand for our professional services personnel to
            install
            our solutions at our customers’ sites, which resulted in additional costs of
            $384,000 related to contracting outsourced professionals compared to
            2006. This
            demand was addressed in the second quarter of 2007 by the acquisition
            of the
            professional services division of Alliance, which added 13 professionals
            to our
            staff and contributed significantly to our increased expenses in the
            three
            months ended June 30, 2007.  The remaining expense increases were due
            to higher communication costs, more software purchases and greater depreciation
            expense.
 
 We
            anticipate these costs will continue to increase in 2007 if the number
            of our
            large, direct customers continues to grow. We also expect that the acquisition
            of the professional services division of Alliance Systems will generate
            additional services costs for us in the future.
 
 ***Gross
            Profit***
 **Three
                        Months Ended**
                      **June
                        30,**
                  
                  
                  **Six
                        Months Ended**
                      **June
                        30,****2007**
                  
                  
                  **2006**
                  
                  
                  **2007**
                  
                  
                  **2006****($
                      in thousands)**Gross
                      profit
                  
                  $
                  18,235
                  
                  
                  $
                  13,976
                  
                  
                  $
                  35,190
                  
                  
                  $
                  27,510Change
                      from prior year period
                  
                  
                  30
                  %
                  
                  
                  18
                  %
                  
                  
                  28
                  %
                  
                  
                  20
                  %Percentage
                      of total revenues
                  
                  
                  68
                  %
                  
                  
                  72
                  %
                  
                  
                  69
                  %
                  
                  
                  73
                  %
 
 
  -
                19
                -
 **-
                back to table of contents -**
  Gross
            profit as a percentage of total revenues decreased during the three and
            six
            months ended June 30, 2007 compared to the same periods in 2006, primarily
            due
            to additional costs of products and services as discussed previously.
            The gross
            margin on our hardware sales is less than the gross margin on our software
            licenses; therefore, as we continue to sell more hardware with our software
            orders, our total gross margin percentage may decrease compared to historical
            margins. Gross margin in any particular quarter is dependent upon our
            product
            mix related to recognized orders and is expected to vary.
  ***Operating
            Expenses***
  *Sales
            and
            Marketing*
 **Three
                        Months Ended**
                      **June
                        30,**
                  
                  
                  **Six
                        Months Ended**
                      **June
                        30,****2007**
                  
                  
                  **2006**
                  
                  
                  **2007**
                  
                  
                  **2006****($
                      in thousands)**Sales
                      and marketing expenses
                  
                  $
                  8,705
                  
                  
                  $
                  6,855
                  
                  
                  $
                  17,349
                  
                  
                  $
                  13,734Change
                      from prior year period
                  
                  
                  27
                  %
                  
                  
                  12
                  %
                  
                  
                  26
                  %
                  
                  
                  14
                  %Percentage
                      of total revenues
                  
                  
                  33
                  %
                  
                  
                  35
                  %
                  
                  
                  34
                  %
                  
                  
                  37
                  %Percentage
                      of net product revenues
                  
                  
                  80
                  %
                  
                  
                  91
                  %
                  
                  
                  84
                  %
                  
                  
                  91
                  %
 
 Sales
              and
              marketing expenses are comprised primarily of compensation expenses,
              travel and
              entertainment expenses and promotional costs related to our sales,
              marketing,
              and channel management operations. Compensation expense increased $926,000
              and
              $2.3 million during the three and six months ended June 30, 2007, respectively,
              which resulted from a 20% increase in our sales and marketing staffing
              at June
              30, 2007 compared to June 30, 2006. In addition, we incurred $486,000
              and
              $505,000 of additional costs during the three and six months ended
              June 30,
              2007, respectively, as a result of various marketing
              activities.  Finally, the increase for the six months ended June 30,
              2007 compared to the same period in 2006 also included additional travel
              related
              expenses of $254,000 and a lump sum severance payment we made to a
              former
              executive officer of $175,000.
 
 Sales
            and
            marketing expenses as a percentage of total revenues and as a percentage
            of net
            product revenues decreased during the three and six months ended June
            30, 2007
            as compared to the same periods in 2006. These decreases reflect efficiencies
            that we have realized in these areas as our revenues continued to
            increase.
 
 *Research
            and
            Development*
 **Three
                        Months Ended**
                      **June
                        30,**
                  
                  
                  **Six
                        Months Ended**
                      **June
                        30,****2007**
                  
                  
                  **2006**
                  
                  
                  **2007**
                  
                  
                  **2006****($
                      in thousands)**Research
                      and development expenses
                  
                  $
                  4,227
                  
                  
                  $
                  3,292
                  
                  
                  $
                  8,124
                  
                  
                  $
                  6,414Change
                      from prior year period
                  
                  
                  28
                  %
                  
                  
                  2
                  %
                  
                  
                  27
                  %
                  
                  
                  0
                  %Percentage
                      of total revenues
                  
                  
                  16
                  %
                  
                  
                  17
                  %
                  
                  
                  16
                  %
                  
                  
                  17
                  %
 
 Research
            and development expenses are comprised primarily of compensation and
            depreciation expenses. During the three and six months ended June 30,
            2007,
            compensation expense increased $683,000 and $1.3 million, respectively,
            as
            compared to the same periods in 2006, as a result of a 27% increase in
            our
            research and development staffing at June 30, 2007 compared to June 30,
            2006. In
            addition, we incurred incremental research and development costs of $114,000
            and
            $198,000 during the three and six months ended June 30, 2007, respectively,
            related to allocable general corporate expenses including rent and property
            taxes.  We also incurred $111,000 and $116,000 of additional expenses
            during the three and six months ended June 30, 2007, respectively, related
            to
            recruiting and consulting fees.
 
 *General
            and
            Administrative*
 **Three
                        Months Ended**
                      **June
                        30,**
                  
                  
                  **Six
                        Months Ended**
                      **June
                        30,****2007**
                  
                  
                  **2006**
                  
                  
                  **2007**
                  
                  
                  **2006****($
                      in thousands)**General
                      and administrative expenses
                  
                  $
                  3,285
                  
                  
                  $
                  2,833
                  
                  
                  $
                  6,350
                  
                  
                  $
                  5,367Change
                      from prior year period
                  
                  
                  16
                  %
                  
                  
                  39
                  %
                  
                  
                  18
                  %
                  
                  
                  32
                  %Percentage
                      of total revenues
                  
                  
                  12
                  %
                  
                  
                  15
                  %
                  
                  
                  12
                  %
                  
                  
                  14
                  %
 
  -
                20
                -
 **-
                back to table of contents -**
  General
            and administrative expenses are comprised of compensation expense and
            general
            corporate expenses that are not allocable to other departments including
            legal
            and other professional fees and bad debt expense. General and administrative
            expenses increased during the three months ended June 30, 2007, as compared
            to
            the same period in 2006, primarily due to an increase in compensation
            expense of
            $137,000 and $482,000 during the three and six months ended June 30,
            2007,
            respectively, as a result of a 25% increase in our general and administrative
            staffing at June 30, 2007 compared to June 30, 2006. We also recognized
            $102,000
            and $121,000 of additional expense related to legal, accounting and professional
            fees during the three and six months ended June 30, 2007, respectively,
            compared
            to the same periods in 2006. Finally, bad debt expense increased $150,000
            for
            the three months ended June 30, 2007.
 
 ***Other
            Income (Expense)***
  *Interest
            Income, Net*
 **Three
                      Months Ended**
                    **June
                      30,**
                  
                  
                  **Six
                      Months Ended**
                    **June
                      30,****2007**
                  
                  
                  **2006**
                  
                  
                  **2007**
                  
                  
                  **2006****($
                      in thousands)**Cash,
                      cash equivalents and short-term investments (average)
                  
                  $
                  31,828
                  
                  
                  $
                  19,519
                  
                  
                  $
                  29,615
                  
                  
                  $
                  17,648Interest
                      income
                  
                  
                  384
                  
                  
                  
                  121
                  
                  
                  
                  856
                  
                  
                  
                  228Return
                      on investment (annualized)
                  
                  
                  4.8
                  %
                  
                  
                  2.5
                  %
                  
                  
                  5.8
                  %
                  
                  
                  2.6
                  %
 
 Interest
              income, net is primarily comprised of interest earned from investments
              and
              interest-bearing cash accounts. Interest expense and fees, which were
              not
              material for any periods reported, were also included in interest income,
              net.
              Interest earned on investments improved during the three and six months
              ended
              June 30, 2007, compared to the same periods in 2006, due to increasing
              cash and
              investment balances, better monitoring of funds in which we have invested
              to
              increase our return on investment and higher interest rates and lower
              fees.
  *Other
            Expense,
            Net*
 **Three
                      Months Ended**
                    **June
                      30,**
                  
                  
                  **Six
                      Months Ended**
                    **June
                      30,****2007**
                  
                  
                  **2006**
                  
                  
                  **2007**
                  
                  
                  **2006****($
                      in thousands)**Other
                      income (expense)
                  
                  $
                  (42
                  )
                  
                  $
                  (12
                  )
                  
                  $
                  (98
                  )
                  
                  $
                  (64
                  )
 
 Other
            expense, net includes foreign currency transaction gains and losses,
            as well as
            foreign tax withholdings. These amounts depend on the amount of revenue
            that is
            generated in certain international currencies, particularly the Euro,
            and the
            exchange gain or loss that results from foreign currency disbursements
            and
            receipts. The increase in the expense during the three and six months
            ended June
            30, 2007 was primarily due to additional foreign tax withholdings compared
            to
            the same periods in 2006.
 
 **Liquidity
            and Capital Resources**
  We
            generate cash from the collections we receive related to licensing our
            contact
            center and IP-PBX applications and from annual license renewals, maintenance
            and
            support and other services revenues. We also have in place an unused
            $3.0
            million line of credit. We use cash primarily for paying our employees
            (including salaries, commissions and benefits), leasing office space,
            paying
            travel expenses, marketing activities, paying vendors for other services
            and
            supplies and purchasing property and equipment.
 
 We
            determine liquidity by combining cash and cash equivalents and short-term
            investments net of any outstanding borrowings on our line of credit as
            shown in
            the table below. Our total liquidity position as of June 30, 2007 improved
            compared with our position as of December 31, 2006 due mainly to increased
            net
            income, increasing deferred revenue balances and strong cash collections.
            We
            believe that our current liquidity position, when combined with our anticipated
            cash flows from operations, will be sufficient to satisfy our operating
            cash
            needs over the next 12 months. If cash flows from operations are less
            than
            anticipated or we have additional cash needs (such as an unfavorable
            outcome in
            legal proceedings), our liquidity may not be sufficient to cover our
            needs. In
            this case, we may be forced to raise additional capital, either through
            the
            capital markets or debt financings. We may not be able to receive favorable
            terms in raising this capital.
 
 **June
                      30,**
                  
                  
                  **December
                      31,****2007**
                  
                  
                  **2006****($
                      in thousands)**Cash
                      and cash equivalents
                  
                  $
                  18,449
                  
                  
                  $
                  13,531Short-term
                      investments
                  
                  
                  13,694
                  
                  
                  
                  13,555Liquidity,
                      net
                  
                  $
                  32,143
                  
                  
                  $
                  27,086
 
  -
                21
                -
 **-
                back to table of contents -**
  Our
            operating activities resulted in net cash provided of $6.9 million and
            $4.3
            million for the six months ended June 30, 2007 and 2006, respectively.
            This
            increase in net cash provided was primarily a result of increased net
            income and
            deferred services revenues offset by a decrease in cash
            collections.
 
 The
            amount that we report as cash and cash equivalents or as temporary investments
            fluctuates depending on investing decisions in each period. Purchases
            of
            short-term investments are reported as a use of cash and the related
            receipt of
            proceeds upon maturity of the investment is reported as a source of
            cash.
 
 Net
            cash
            used in investing activities was $3.3 million and $3.8 million for the
            six
            months ended June 30, 2007 and 2006, respectively. During the second
            quarter of
            2007, we used $853,000 of cash from operations to acquire the professional
            services division of Alliance.  During the six months ended June 30,
            2007, we purchased $3.4 million of additional available-for-sale investments;
            however these additional purchases were offset by $6.2 million of additional
            available-for-sale investments that matured during the first six months
            of 2007
            compared to the same period in 2006. We also purchased property and equipment
            totaling $2.6 million during the first six months of 2007 compared to
            $1.0
            million during the same period in 2006. These purchases related mainly
            to
            hardware and leasehold improvements for our corporate headquarters and
            regional
            offices. As our operations continue to grow and we add new employees,
            we
            anticipate that our purchases of property and equipment will continue
            to
            increase in future periods.
 
 Net
            cash
            provided by financing activities was $1.3 million and $1.8 million for
            the six
            months ended June 30, 2007 and 2006, respectively. The decrease in cash
            provided
            was mainly due to lower proceeds from stock options that were exercised
            during
            the six months ended June 30, 2007.
  On
                June
                19, 2007, we entered into an amendment of our corporate office operating
                lease under which the leased space will be expanded by approximately
                79,385
                rentable square feet in an office building currently under construction
                and
                adjacent to our corporate headquarters. The rent for the additional
                space
                through the lease expiration date (March 31, 2018) will be approximately
                $16.3
                million, payable in pro-rata monthly installments through the lease
                term, as
                defined in the amendment. Rent payments will commence as we utilize
                the
                additional space, which is expected to be no earlier than March 1,
                2008 and as a
                result, there was no financial statement impact for the three months
                ended June
                30, 2007.  In consideration for entering into the amendment, the
                landlord agreed to pay us a discretionary allowance of $450,000 which
                is payable
                as we utilize the additional space in the office building. We will
                use the
                allowance for certain costs associated with our corporate headquarters
                and/or
                the additional space, as defined in the amendment.
 
 On
            October 19, 2006, we filed with the SEC a registration statement on Form
            S-3
            utilizing the “shelf” registration process. This registration statement has not
            yet been declared effective by the SEC but if and when effective, it
            will allow
            us to offer and sell up to 3,000,000 shares of our common stock from
            time to
            time in one or more transactions. In addition, under this shelf registration
            statement, Dr. Donald E. Brown, our Chairman of the Board, President
            and CEO,
            registered 1,000,000 shares of our common stock that he owns for sale
            from time
            to time. Although the shelf registration statement, if and when effective,
            will
            permit us to offer and sell up to 3,000,000 shares of our common stock,
            doing so
            remains at the discretion of the Board of Directors, and there is no
            assurance
            that we would be able to complete any such offering of our common
            stock.
 
 The
              obligations listed in the table below relate to operating lease obligations
              for
              additional office space adjacent to our corporate headquarters, as
              discussed
              above, and office leases in the United States entered into during the
              second
              quarter of 2007 and are incremental to the operating lease obligations
              disclosed
              in our Annual Report on Form 10-K for the year ended December 31, 2006
              and
              Quarterly Report on Form 10-Q for the period ended March 31, 2007.
              There have
              been no additional material changes in our contractual obligations
              as of June
              30, 2007.
 
 **Payments
                        Due by Period****Total**
                  
                  
                  **Less
                        than**
                      **1
                        Year**
                  
                  
                  **1-3
                        Years**
                  
                  
                  **3-5
                        Years**
                  
                  
                  **More
                        than**
                      **5
                        Years****Contractual
                      Obligations**Operating
                      lease obligations
                  
                  $
                  16,743,796
                  
                  
                  $
                  67,942
                  
                  
                  $
                  2,385,032
                  
                  
                  $
                  3,249,030
                  
                  
                  $
                  11,041,792
 
 **Off-Balance
            Sheet Arrangements**
 
 Except
            as
            set forth above in the Contractual Obligations table, we have no off-balance
            sheet arrangements that have or are reasonably likely to have a current
            or
            future impact on our financial condition, changes in financial condition,
            revenues or expenses, results of operations, liquidity, capital expenditures
            or
            capital resources as of June 30, 2007.
 
 -
                  22
                  -
 **-
                  back to table of contents -**
  **Critical
            Accounting Policies and Estimates**
  We
            believe the accounting policies listed below are important to understanding
            our
            historical and future performance, as these policies affect the reported
            amounts
            of revenues and income and are the more significant areas involving management’s
            judgments and estimates. These policies, and our procedures related to
            these
            policies, are described below. See also Note 2 of Notes to Consolidated
            Financial Statements included in our Annual Report on Form 10-K for the
            year
            ended December 31, 2006 for a further summary of our other significant
            accounting policies.
 
 ***Sources
            of Revenues and Revenue Recognition Policy***
 
 We
            generate product revenues from licensing the right to use our software
            applications and in certain instances providing hardware as a component
            of our
            solution, and we generate services revenues primarily from annual support
            fees,
            annual renewal fees, professional services and educational
            services.
 
 *Product
            Revenues*
 
 Our
            license agreements are either perpetual or annually renewable.  For
            any revenues to be recognized from a license agreement, the following
            criteria
            must be met:
 
 ·
                  Persuasive
                      evidence of an arrangement exists;
 
 ·
                  The
                      fee is fixed or determinable;
 
 ·
                  Collection
                      is probable; and
 
 ·
                  Delivery
                      has occurred.
 
 For
            a
            perpetual license agreement, upon meeting the revenue recognition criteria
            above, we immediately recognize as product revenues the amount of initial
            license fees if sufficient vendor specific objective evidence of fair
            value
            (“VSOE”) exists to support allocating a portion of the total fee to the
            undelivered elements of the arrangement. If sufficient VSOE of the undelivered
            elements does not exist, we recognize the initial license fee as product
            revenues ratably over the initial term of the support agreement once
            support is
            the only undelivered element. The support period is generally 12 months
            but may
            be up to 18 months for initial orders because support begins when the
            licenses
            are downloaded, when support commences, or no more than six months following
            the
            contract date. We determine VSOE of support in perpetual agreements based
            on
            substantive renewal rates the customer must pay to renew the support.
            The VSOE
            of other services is based on amounts charged when the services are sold
            in
            stand-alone sales.
 
 For
            an
            annually renewable license agreement, which includes bundled support,
            upon
            meeting the revenue recognition criteria above, we recognize a majority
            of the
            initial license fees under these agreements as product revenues ratably
            over the
            initial license period, which is generally 12 months, and the remainder
            of the
            initial license fees are recognized as services revenues over the same
            time
            period.
 
 We
            recognize revenues related to any hardware sales when the hardware is
            delivered
            and all other revenue recognition criteria are met.
 
 *Services
            Revenues*
 
 Services
            revenues are primarily recognized for renewal fees and support related
            to
            annually renewable license agreements and support fees for perpetual
            license
            agreements. For annually renewable agreements, the allocation of the
            initial
            order between product revenues and services revenues is based on the
            average
            renewal rates of all time based contracts. We apply the allocation of
            product
            revenues and services revenues consistently to all annually renewable
            agreements. Under annually renewable license agreements, after the initial
            license period, our customers may renew their license agreement for an
            additional period, typically 12 months, by paying a renewal fee. The
            revenue for
            the annual renewal fees are all classified under services revenue and
            the
            revenue is recognized ratably over the contract period. Under perpetual
            license
            agreements, we recognize annual support fees as services revenues ratably
            over
            the post-contract support period, which is typically 12 months.
  We
            also
            generate revenues from other services that we provide to our partners
            and
            customers. These additional revenues include fees for professional services
            and
            educational services. Revenues from professional services, which include
            implementing our products for a customer, and educational services, which
            consist of training courses for partners and customers, are recognized
            as the
            related services are performed.
 
  -
                23
                -
 **-
                back to table of contents -**
  ***Stock-Based
            Compensation Expense***
 
 We
            account for our employee and director stock options in accordance with
            SFAS 123R
            and the guidance of SAB 107, which requires the measurement and recognition
            of
            compensation expense for all share-based payment awards made to employees
            and
            directors, based on fair values.  As permitted by SFAS 123R, we
            continued to use the Black-Scholes option-pricing model as our method
            of
            valuation for share-based payment awards. Our determination of fair value
            of
            share-based payment awards on the date of grant using an option-pricing
            model is
            affected by our stock price as well as assumptions regarding a number
            of highly
            complex and subjective variables. These variables include, but are not
            limited
            to, our expected stock price volatility over the term of the awards and
            an
            expected risk-free rate of return. If factors change and we use different
            assumptions for estimating stock-based compensation expense in future
            periods,
            stock-based compensation expense may differ materially in the future
            from that
            recorded in the current period.
 
 Stock-based
            compensation expense for employee stock options recognized under SFAS
            123R for
            the three and six months ended June 30, 2007 was $806,000 and $1.5 million,
            respectively, compared to $668,000 and $1.2 million during the same periods
            in
            2006.
 
 ***Income
            Taxes***
 
 Income
            taxes are accounted for under the asset and liability method. Deferred
            tax
            assets and liabilities are recognized for the future tax consequences
            attributable to differences between the financial statement carrying
            amounts of
            existing assets and liabilities and their respective tax bases and operating
            loss and tax credit carry-forwards. Deferred tax assets and liabilities
            are
            measured using enacted tax rates expected to apply to taxable income
            in the
            years in which those temporary differences are expected to be recovered
            or
            settled. The effect on deferred tax assets and liabilities of a change
            in tax
            rates is recognized in income in the period that includes the enactment
            date.
 
 SFAS
            No.
            109, *Accounting for Income Taxes*, establishes financial accounting and
            reporting standards for the effect of income taxes. We are subject to
            income
            taxes in both the United States and numerous foreign jurisdictions. Significant
            judgment is required in evaluating our tax positions and determining
            our
            provision for income taxes. The objectives of accounting for income taxes
            are to
            recognize the amount of taxes payable or refundable for the current year
            and
            deferred tax liabilities and assets for the future tax consequences of
            events
            that have been recognized in an entity’s financial statements or tax returns.
            Variations in the actual outcome of these future tax consequences could
            materially impact our financial position, results of operations, or cash
            flows.
 
 In
            assessing the recoverability of deferred tax assets, management considers
            whether it is more likely than not that some portion or all of the deferred
            tax
            assets will not be realized. The ultimate realization of deferred tax
            assets is
            dependent upon generation of future taxable income during the periods
            in which
            temporary differences become deductible. Management considers projected
            future
            taxable income and tax planning strategies in making this assessment
            and
            ensuring that the deferred tax asset valuation allowance is adjusted
            as
            appropriate.
 
 See
            Note
            7 of Notes to Condensed Consolidated Financial Statements for further
            information on our income taxes.
 
 ***Allowance
            for Doubtful Accounts Receivable***
 
 We
            record
            bad debt expense based on a percentage of revenue reported each period.
            We then
            review the allowance for doubtful accounts for each reporting period
            based on a
            detailed analysis of our accounts receivable to determine that the amount
            of the
            allowance for doubtful accounts receivable is appropriately stated at
            the end of
            that period. In the analysis of accounts receivable, we primarily consider
            the
            age of the partner’s or customer’s receivable and also consider the
            creditworthiness of the partner or customer, the economic conditions
            of the
            customer’s industry, and general economic conditions, among other factors. If
            payment is not made timely, we contact the customer or partner to try
            to obtain
            payment. If this is not successful, we institute other collection practices
            such
            as generating collection letters, involving our sales representatives
            and
            ultimately terminating the customer’s or partner’s access to future upgrades,
            licenses and customer support. Once all collection efforts are exhausted,
            the
            receivable is written off against the allowance for doubtful
            accounts.
 
 ***Research
            and Development***
 
 Through
            June 30, 2007, all research and development expenditures have been expensed
            as
            incurred. Based on our product development process and technological
            feasibility, the date at which capitalization of development costs may
            begin is
            established upon completion of a working model. Costs incurred between
            completion of the working model and the point at which the product is
            ready for
            general release have been insignificant.
 
 ***Legal
            Proceedings***
 
 Liabilities
            for loss contingencies arising from claims, assessments, litigation,
            fines, and
            penalties and other sources are recorded when it is probable that a liability
            has been incurred and the amount of the assessment and/or remediation
            can be
            reasonably estimated. Legal costs incurred in connection with loss contingencies
            are expensed as incurred.
 
 -
                  24
                  -
 **-
                  back to table of contents -**
  **Item
                      3.**
                  **Quantitative
                      and Qualitative Disclosures about Market
                      Risk.**
 
 We
            develop products in the United
            States and license our products in the Americas,Europe, the Middle
            East andAfrica andAsia/Pacific.
            As a result, our financial results
            could be affected by various factors, including changes in foreign currency
            exchange rates or weak economic conditions in foreign markets. As most
            sales are
            currently made in U.S. dollars, a strengthening of the dollar could make
            our
            products less competitive in foreign markets. Additionally, as our business
            matures in foreign markets, we may offer our products and services in
            certain
            other local currencies. As a result, we will be subject to foreign currency
            fluctuations, which may have an adverse affect on our
            company.
 
 We
            manage
            our interest rate risk by maintaining an investment portfolio with debt
            instruments of high credit quality and relatively short average maturities.
            We
            also manage interest rate risk by maintaining sufficient cash and cash
            equivalent balances such that we are typically able to hold our investments
            to
            maturity. We have a line of credit with a variable interest rate based
            upon the
            bank’s prime rate on which we incur interest expense when the line is
            utilized.
 
 **Item
                      4.**
                  **Controls
                      and
                      Procedures.**
 
 We
            maintain a set of disclosure controls and procedures that are designed
            to ensure
            that information required to be disclosed by us in the reports filed
            by us under
            the Securities Exchange Act of 1934, as amended (the “Exchange Act”) is
            recorded, processed, summarized and reported within the time periods
            specified
            in the SEC’s rules and forms. We carried out an evaluation, under the
            supervision and with the participation of our management, including our
            President and Chief Executive Officer (principal executive officer) and
            our
            Chief Financial Officer (principal financial officer), of the effectiveness
            of
            the design and operation of our disclosure controls and procedures as
            of June
            30, 2007 pursuant to Rule 13a-15(b) of the Exchange Act. Based on that
            evaluation, our principal executive officer and principal financial officer
            concluded that our disclosure controls and procedures were
            effective.
 
 There
            have been no changes in our internal control over financial reporting
            that
            occurred during the quarter ended June 30, 2007 that have materially
            affected,
            or are reasonably likely to materially affect, our internal control over
            financial reporting.
 
 **PART
            II. OTHER INFORMATION**
 
 **Item
                      1.**
                  **Legal
                      Proceedings.**
  The
            information set forth in Note 6 of Notes to Condensed Consolidated Financial
            Statements included in Part I, Item 1 of this report is incorporated
            herein by
            reference.
  **Item
                      1A.**
                  **Risk
                      Factors.**
 
 In
            addition to the information set forth in this Report and before deciding
            to
            invest in, or retain, shares of our common stock, you also should carefully
            review and consider the information contained in our other reports and
            periodic
            filings that we make with the SEC, including, without limitation, the
            information contained under the caption Item 1A “Risk Factors” in our Annual
            Report on Form 10-K for the year ended December 31, 2006. Those risk
            factors
            could materially affect our business, financial condition and results
            of
            operations.
  The
            risks
            that we describe in our public filings are not the only risks that we
            face.
            Additional risks and uncertainties not currently known to us, or that
            we
            presently deem to be immaterial, also may materially adversely affect
            our
            business, financial condition and results of operations. During the three
            months
            ended June 30, 2007, there were no material changes from risk factors
            previously
            disclosed in our Annual Report on Form 10-K for the year ended December
            31,
            2006.
 -
            25
            -
 **-
            back to table of contents -**
 
 **Item
                  4.**
              **Submission
                  of Matters to a Vote of Security
                  Holders.**
 
 We
        held
        our Annual Meeting of Shareholders on June 8, 2007. At that meeting, our
        shareholders reelected Mark E. Hill and elected Michael C. Heim as Directors
        of
        the Company for three-year terms or until their successors are elected and
        have
        qualified
 
 The
        final
        results of the votes taken at the annual meeting were as follows:
 
 **Election
                  of Directors**
              
              **Votes
                  FOR**
              
              
              **Votes
                  WITHHELD**Mark
                  E. Hill
              
              
              15,104,869
              
              
              
              339,784Michael
                  C. Heim
              
              
              14,727,090
              
              
              
              717,563
 
 In
        addition, the following Directors also have terms in office that continue
        until
        the annual meeting of shareholders in the year indicated:
 
 **Director**
              **Year**Donald
                  E. Brown, M.D.
              2008Richard
                  A. Reck
              2008Edward
                  L. Hamburg, Ph.D.
              2009Samuel
                  F. Hulbert, Ph.D.
              2009
 
 **Item
                  6.**
              **Exhibits.**
 
 (a)
              Exhibits
 
 3.1
              
              Restated
                  Articles of Incorporation of the Company (incorporated herein by
                  reference
                  from the same exhibit number to the Company’s Registration Statement on
                  Form S-1 (Registration No. 333-79509))3.2
              
              By-Laws
                  of the Company, as amended to date (incorporated herein by reference
                  from
                  the same exhibit number to the Company’s Registration Statement on Form
                  S-1 (Registration No. 333-79509))10
              
              Third
                  Lease Amendment, dated June 19, 2007, between the Company and Duke
                  Realty
                  Limited Partnership (formerly Duke-Weeks Realty Limited Partnership)
                  (incorporated herein by reference from the same exhibit number
                  to the
                  Company’s Current Report on Form 8-K filed June 25,
                  2007)10.6
              
              Asset
                  Purchase Agreement dated as of April 17, 2007 between the Company
                  and
                  Alliance Systems Ltd. (incorporated herein by reference from the
                  same
                  exhibit number to the Company’s Current Report on Form 8-K filed April 23,
                  2007)10.26
              
              Summary
                  of Certain Director and Executive
                  Compensation
 
 -
              26
              -
 **-
              back to table of contents -**
 
 
 10.37
              
              Form
                  of Non-Employee Director Stock Option Agreement under 2006 Equity
                  Incentive Plan10.38
              
              Form
                  of Non-Employee Director Change of Control Agreement31.1
              
              Certification
                  of the Chief Executive Officer pursuant to Rule 13a-14(a)/15d-14(a)
                  of the
                  Securities Exchange Act of 1934, as adopted pursuant to Section
                  302 of the
                  Sarbanes-Oxley Act of 200231.2
              
              Certification
                  of the Chief Financial Officer pursuant to Rule 13a-14(a)/15d-14(a)
                  of the
                  Securities Exchange Act of 1934, as adopted pursuant to Section
                  302 of the
                  Sarbanes-Oxley Act of 200232.1
              
              Certification
                  of the Chief Executive Officer, pursuant to 18 U. S. C. Section
                  1350, as
                  adopted pursuant to Section 906 of the Sarbanes-Oxley Act of
                  200232.2
              
              Certification
                  of the Chief Financial Officer, pursuant to 18 U. S. C. Section
                  1350, as
                  adopted pursuant to Section 906 of the Sarbanes-Oxley Act of
                  2002
 
 
 -
              27
              -
 **-
              back to table of contents -**
  **SIGNATURES**
  Pursuant
        to the requirements of the Securities Exchange Act of 1934, the registrant
        has
        duly caused this report to be signed on its behalf by the undersigned hereunto
        duly authorized.
  **Interactive
                  Intelligence, Inc.**
                (Registrant)Date:   August
                  9, 2007
              
              
              
              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)***






- 28
      -