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 September 30, 2009





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)Not
      Applicable(Former
      name, former address and former fiscal year, if changed since last
      report)








Indicate by check mark 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     R
              No       ̈
 Indicate
by check mark whether the registrant has submitted electronically and posted on
its corporate Web site, if any, every Interactive Data File required to be
submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this
chapter) during the preceding 12 months (or for such shorter period that the
registrant was required to submit and post such files).




Yes      ̈
            No       ̈





Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filer, a non-accelerated filer, or a smaller reporting company. See
the definitions of “large accelerated filer,” “accelerated filer” and “smaller
reporting company” in Rule 12b-2 of the Exchange Act. (Check One):





Large
      accelerated filer
            *
            
            
            Accelerated
      filer
            RNon-accelerated
      filer
            *(Do not check if a
      smaller reporting company)
            Smaller
      reporting company
            *





Indicate by check mark whether the
registrant is a shell company (as defined in Rule 12b-2 of the Exchange
Act).Yes*NoR





As of
October 31, 2009, there were 17,275,190
shares outstanding of the registrant’s common stock, $0.01 par
value.














TABLE OF
CONTENTS





PART
      I. FINANCIAL INFORMATION
            
            PageItem
      1.
            Financial
      Statements.Condensed
      Consolidated Balance Sheets as of September 30, 2009 and December 31,
      2008
            
            
            1Condensed
      Consolidated Statements of Income for the Three and Nine Months Ended
      September 30, 2009 and 2008
            
            
            2Condensed
      Consolidated Statement of Shareholders’ Equity for the Nine Months Ended
      September 30, 2009
            
            
            3Condensed
      Consolidated Statements of Cash Flows for the Nine Months Ended September
      30, 2009 and 2008
            
            
            4Notes
      to Condensed Consolidated Financial Statements
            
            
            5Item
      2.
            Management’s
      Discussion and Analysis of Financial Condition and Results of
      Operations.
            
            
            12Item
      3.
            Quantitative
      and Qualitative Disclosures About Market Risk.
            
            
            20Item
      4.
            Controls
      and Procedures.
            
            
            20PART
      II. OTHER INFORMATIONItem
      1.
            Legal
      Proceedings.
            
            
            20Item
      1A.
            Risk
      Factors.
            
            
            20Item
      6.
            Exhibits.
            
            
            21SIGNATURE
            
            
            22


i


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 September 30, 2009 and December 31, 2008


(In
thousands, except share and per share amounts)





September
      30,
                2009
            
            
            December
      31,
                2008(unaudited)AssetsCurrent
      assets:Cash
      and cash equivalents
            
            $
            50,584
            
            
            $
            34,705Short-term
      investments
            
            
            9,427
            
            
            
            10,805Accounts
      receivable, net of allowance for doubtful accounts of
              $1,014
      at September 30, 2009 and $1,004 at December 31, 2008
            
            
            24,723
            
            
            
            27,533Deferred
      tax assets, net
            
            
            4,719
            
            
            
            6,017Prepaid
      expenses
            
            
            4,528
            
            
            
            5,507Other
      current assets
            
            
            3,924
            
            
            
            1,995Total
      current assets
            
            
            97,905
            
            
            
            86,562Property
      and equipment, net
            
            
            8,907
            
            
            
            10,762Deferred
      tax assets, net
            
            
            5,550
            
            
            
            5,136Other
      assets, net
            
            
            4,864
            
            
            
            2,723Total
      assets
            
            $
            117,226
            
            
            $
            105,183Liabilities
      and Shareholders’ EquityCurrent
      liabilities:Accounts
      payable and accrued liabilities
            
            $
            10,507
            
            
            $
            11,361Accrued
      compensation and related expenses
            
            
            4,529
            
            
            
            3,486Deferred
      product revenues
            
            
            3,297
            
            
            
            4,754Deferred
      services revenues
            
            
            31,585
            
            
            
            31,457Total
      current liabilities
            
            
            49,918
            
            
            
            51,058Deferred
      revenue
            
            
            6,576
            
            
            
            6,878Total
      liabilities
            
            
            56,494
            
            
            
            57,936Commitments
      and contingencies (Note 7)
            
            
            --
            
            
            
            --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; 17,222,147
      issued and outstanding at
                September 30, 2009 and
      16,928,089issued and
      outstanding at December 31, 2008
            
            
            172
            
            
            
            169Treasury
      stock
            
            
            (6,736
            )
            
            
            (9,714
            )Additional
      paid-in capital
            
            
            88,965
            
            
            
            83,604Accumulated
      deficit
            
            
            (21,669
            )
            
            
            (26,812
            )Total
      shareholders’ equity
            
            
            60,732
            
            
            
            47,247Total
      liabilities and shareholders’ equity
            
            $
            117,226
            
            
            $
            105,183





See Accompanying
Notes to Condensed Consolidated Financial Statements


1


Interactive Intelligence, Inc.


Condensed
Consolidated Statements of Income (unaudited)


For
the Three and Nine Months Ended September 30, 2009 and 2008


(In
thousands, except per share amounts)





Three
      Months Ended
                September
      30,
            
            
            Nine
      Months Ended
                September
      30,2009
            
            
            2008
            
            
            2009
            
            
            2008(Note
      1)
            
            
            
            
            
            (Note
      1)Revenues:Product
            
            $
            15,557
            
            
            $
            14,687
            
            
            $
            45,100
            
            
            $
            44,853Services
            
            
            17,613
            
            
            
            15,369
            
            
            
            50,441
            
            
            
            45,296Total
      revenues
            
            
            33,170
            
            
            
            30,056
            
            
            
            95,541
            
            
            
            90,149Cost
      of revenues:Product
            
            
            3,950
            
            
            
            3,702
            
            
            
            12,320
            
            
            
            10,741Services
            
            
            5,549
            
            
            
            6,059
            
            
            
            16,758
            
            
            
            18,044Total
      cost of revenues
            
            
            9,499
            
            
            
            9,761
            
            
            
            29,078
            
            
            
            28,785Gross
      profit
            
            
            23,671
            
            
            
            20,295
            
            
            
            66,463
            
            
            
            61,364Operating
      expenses:Sales
      and marketing
            
            
            9,696
            
            
            
            9,547
            
            
            
            28,877
            
            
            
            29,870Research
      and development
            
            
            6,135
            
            
            
            5,801
            
            
            
            17,747
            
            
            
            16,102General
      and administrative
            
            
            3,562
            
            
            
            3,376
            
            
            
            10,166
            
            
            
            11,162Total
      operating expenses
            
            
            19,393
            
            
            
            18,724
            
            
            
            56,790
            
            
            
            57,134Operating
      income
            
            
            4,278
            
            
            
            1,571
            
            
            
            9,673
            
            
            
            4,230Other
      income (expense):Interest
      income
            
            
            50
            
            
            
            329
            
            
            
            232
            
            
            
            1,132Other
      income (expense), net
            
            
            480
            
            
            
            (277
            )
            
            
            706
            
            
            
            (152
            )Total
      other income, net
            
            
            530
            
            
            
            52
            
            
            
            938
            
            
            
            980Income
      before income taxes
            
            
            4,808
            
            
            
            1,623
            
            
            
            10,611
            
            
            
            5,210Income
      tax expense
            
            
            2,005
            
            
            
            699
            
            
            
            4,488
            
            
            
            2,324Net
      income
            
            $
            2,803
            
            
            $
            924
            
            
            $
            6,123
            
            
            $
            2,886Net
      income per share:Basic
            
            $
            0.16
            
            
            $
            0.05
            
            
            $
            0.36
            
            
            $
            0.16Diluted
            
            
            0.15
            
            
            
            0.05
            
            
            
            0.34
            
            
            
            0.15Shares
      used to compute net income per share:Basic
            
            
            17,148
            
            
            
            17,976
            
            
            
            17,038
            
            
            
            17,969Diluted
            
            
            18,486
            
            
            
            18,855
            
            
            
            18,125
            
            
            
            19,059








See
Accompanying Notes to Condensed Consolidated Financial Statements








2


Interactive Intelligence, Inc.


Condensed
Consolidated Statement of Shareholders’ Equity (unaudited)


For
the Nine Months Ended September 30, 2009


(In
thousands)





Common
      Stock
            
            
            Treasury
            
            
            Additional
              Paid-in
            
            
            AccumulatedShares
            
            
            Amount
            
            
            Stock
            
            
            Capital
            
            
            Deficit
            
            
            TotalBalances,
      December 31, 2008
            
            
            16,928
            
            
            $
            169
            
            
            $
            (9,714
            )
            
            $
            83,604
            
            
            $
            (26,812
            )
            
            $
            47,247Stock-based
      compensation
            
            
            --
            
            
            
            --
            
            
            
            --
            
            
            
            2,547
            
            
            
            --
            
            
            
            2,547Exercise
      of stock options
            
            
            270
            
            
            
            3
            
            
            
            2,742
            
            
            
            --
            
            
            
            (933
            )
            
            
            1,812Issuances
      of common stock
            
            
            24
            
            
            
            --
            
            
            
            236
            
            
            
            --
            
            
            
            (47
            )
            
            
            189Tax
      benefits from stock-based compensation
            
            
            --
            
            
            
            --
            
            
            
            --
            
            
            
            2,814
            
            
            
            --
            
            
            
            2,814Comprehensive
      income:Net
      income
            
            
            --
            
            
            
            --
            
            
            
            --
            
            
            
            --
            
            
            
            6,123
            
            
            
            6,123Total
      comprehensive income
            
            
            --
            
            
            
            --
            
            
            
            --
            
            
            
            --
            
            
            
            6,123
            
            
            
            6,123Balances,
      September 30, 2009
            
            
            17,222
            
            
            $
            172
            
            
            $
            (6,736
            )
            
            $
            88,965
            
            
            $
            (21,669
            )
            
            $
            60,732





See
Accompanying Notes to Condensed Consolidated Financial
Statements


3


Interactive Intelligence, Inc.


Condensed
Consolidated Statements of Cash Flows (unaudited)


For
Nine Months Ended September 30, 2009 and 2008


(In
thousands)





Nine
      Months Ended
                September
      30,2009
            
            
            2008Operating
      activities:Net
      income
            
            $
            6,123
            
            
            $
            2,886Adjustments
      to reconcile net income to net cash provided by operating
      activities:Depreciation
            
            
            3,139
            
            
            
            2,621Stock-based
      compensation expense
            
            
            2,547
            
            
            
            2,315Tax
      benefits from stock-based payment arrangements
            
            
            (2,814
            )
            
            
            (177
            )Deferred
      income tax
            
            
            884
            
            
            
            1,785Accretion
      of investment income
            
            
            (172
            )
            
            
            (104
            )Changes
      in operating assets and liabilities:Accounts
      receivable
            
            
            2,872
            
            
            
            2,296Prepaid
      expenses
            
            
            1,009
            
            
            
            204Other
      current assets
            
            
            (1,928
            )
            
            
            (1,099
            )Other
      assets
            
            
            281
            
            
            
            (397
            )Accounts
      payable and accrued liabilities
            
            
            1,969
            
            
            
            2,845Accrued
      compensation and related expenses
            
            
            1,043
            
            
            
            (792
            )Deferred
      product revenues
            
            
            (1,349
            )
            
            
            (1,505
            )Deferred
      services revenues
            
            
            (566
            )
            
            
            527Net
      cash provided by operating activities
            
            
            13,038
            
            
            
            11,405Investing
      activities:Sales
      of available-for-sale investments
            
            
            13,100
            
            
            
            20,050Purchases
      of available-for-sale investments
            
            
            (11,550
            )
            
            
            (17,890
            )Purchases
      of property and equipment
            
            
            (1,275
            )
            
            
            (6,186
            )Acquisition
      of intangible and other assets, net of cash and cash equivalents
      acquired
            
            
            (2,249
            )
            
            
            --Net
      cash used in investing activities
            
            
            (1,974
            )
            
            
            (4,026
            )Financing
      activities:Proceeds
      from stock options exercised
            
            
            1,812
            
            
            
            717Proceeds
      from issuance of common stock
            
            
            189
            
            
            
            205Repurchase
      of treasury stock
            
            
            --
            
            
            
            (3,361
            )Tax
      benefits from stock-based payment arrangements
            
            
            2,814
            
            
            
            177Net
      cash provided by (used in) financing activities
            
            
            4,815
            
            
            
            (2,262
            )Net
      increase in cash and cash equivalents
            
            
            15,879
            
            
            
            5,117Cash
      and cash equivalents, beginning of period
            
            
            34,705
            
            
            
            29,359Cash
      and cash equivalents, end of period
            
            $
            50,584
            
            
            $
            34,476Cash
      paid during the period for:Income
      taxes
            
            $
            533
            
            
            $
            195Other
      non-cash item:Purchases
      of property and equipment payable at end of period
            
            $
            42
            
            
            $
            594





See
Accompanying Notes to Condensed Consolidated Financial
Statements


4


Interactive Intelligence, Inc.


Notes
to Condensed Consolidated Financial Statements


September
30, 2009 and 2008 (unaudited)





1.
            FINANCIAL
      STATEMENT PRESENTATION





The
accompanying unaudited condensed consolidated financial statements of
Interactive Intelligence, Inc. (the “Company”) have been prepared in conformity
with accounting principles generally accepted in the United States of America
(“U.S. GAAP”) and with the instructions for Form 10-Q and Article 10 of
Regulation S-X for interim financial information. Accordingly, certain
information and note disclosures normally included in the Company’s financial
statements prepared in accordance with U.S. GAAP have been condensed, or
omitted, pursuant to the rules and regulations of the United States Securities
and Exchange Commission (the “SEC”).





The
preparation of the Company’s condensed consolidated financial statements
requires management to make estimates and assumptions that affect reported
amounts of assets and liabilities, at the respective balance sheet dates, and
the reported amounts of revenues and expenses during the respective reporting
periods. Despite management’s best effort to establish good faith estimates and
assumptions, actual results could differ from these estimates. In management’s
opinion, the Company’s accompanying condensed consolidated financial statements
include all adjustments necessary (which are of a normal and recurring nature,
except as otherwise noted) for the fair presentation of the results of the
interim periods presented.





The
Company’s accompanying condensed consolidated financial statements as of
December 31, 2008 have been derived from the Company’s audited consolidated
financial statements at that date but do not include all of the information and
notes required by U.S. GAAP for complete financial statements. These
accompanying condensed consolidated financial statements should be read in
conjunction with the Company’s audited consolidated financial statements for the
year ended December 31, 2008, included in the Company’s most recent Annual
Report on Form 10-K as filed with the SEC on March 9, 2009. 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.





Principles
of Consolidation





The
accompanying consolidated financial statements include the accounts of the
Company and its wholly-owned subsidiaries after elimination of all significant
intercompany accounts and transactions.





Reclassifications





Effective
April 1, 2009, the Company began presenting gains and losses resulting from
foreign currency fluctuations within other income, net. Previously, the Company
included a portion of these gains and losses within operating expense. The
Company changed its presentation as such gains and losses arising from the
adjustment of foreign currency fluctuations are incidental to its operations.
The Company reclassified $126,000 of foreign currency losses for the three
months ended March 31, 2009 and $206,000 and $126,000 of foreign currency losses
for the three and nine months ended September 30, 2008, respectively, from
operating expense to other income, net on the accompanying condensed
consolidated statements of income. This reclassification did not have any impact
on the overall results previously reported.





Effective
July 1, 2009, the Company began presenting changes in the issuances of common
stock on the accompanying condensed consolidated statement of shareholders'
equity under treasury stock and accumulated deficit. Previously, the Company had
included these changes under additional paid-in capital. These changes result
from purchases of the Company’s stock by its employees under the Employee Stock
Purchase Program. The purchased shares will be issued from treasury stock,
similar to exercises of stock options, until the treasury stock is depleted. The
reclassification did not have any impact on the overall results previously
reported.





2.
            SUMMARY
      OF CERTAIN ACCOUNTING POLICIES AND RECENT ACCOUNTING
      PRONOUNCEMENTS





The
Company’s interim critical accounting policies and estimates include the
recognition of income taxes using an estimated annual effective tax
rate.  For a complete summary of the Company’s other significant
accounting policies and other critical accounting estimates, refer to Note 2 of
Notes to Consolidated Financial Statements included in the Company’s Annual
Report on Form 10-K for the year ended December 31, 2008.
 
 During
the nine months ended September 30, 2009, there were no material changes to the
Company’s significant accounting policies or critical accounting
estimates.





In June
2009, the Financial Accounting Standards Board (“FASB”) established the FASB
Accounting Standards CodificationTM (“Codification”) as the source of
authoritative U.S. GAAP recognized by the FASB to be applied by nongovernmental
entities in the preparation of financial statements.  This guidance
was included in the Codification under FASB Accounting Standard Codification
(“ASC”) Topic 105, Generally
Accepted Accounting Principles.  All prior accounting standard
documents were superseded by the Codification and any accounting literature not
included in the Codification is no longer authoritative. Rules and interpretive
releases of the SEC issued under the authority of federal securities laws will
continue to be sources of authoritative U.S. GAAP for SEC
registrants.  The Codification became effective for the Company
beginning with the third quarter of 2009.  Therefore, beginning with
the third quarter of 2009, all references made by the Company in its condensed
consolidated financial statements use the new Codification numbering
system.  The Codification does not change or alter existing U.S. GAAP
and, therefore, did not have an impact on the Company’s condensed consolidated
financial statements.
 
 In
December 2007, the FASB established guidance under FASB ASC Topic 805, Business Combinations(“FASB
ASC 805”) and FASB ASC Paragraph 810-10-65-1, Noncontrolling Interests in
Consolidated Financial Statements – an amendment to ARB No. 51(“FASB ASC
810-10-65-1”). FASB ASC 805 and FASB ASC 810-10-65-1 require most identifiable
assets, liabilities, noncontrolling interests, and goodwill acquired in a
business combination to be recorded at “full fair value” and require
noncontrolling interests (previously referred to as minority interests) to be
reported as a component of equity, which changes the accounting for transactions
with noncontrolling interest holders. The guidance became effective for periods
beginning on or after December 15, 2008, and earlier adoption was prohibited.
FASB ASC 805 applies to business combinations occurring after the effective
date. FASB ASC 810-10-65-1 applies prospectively to all noncontrolling
interests, including any that arose before the effective date. Upon adoption of
FASB ASC 805 and FASB ASC 810-10-65-1, there was no material impact on the
Company’s condensed consolidated financial statements.


5


In April
2009, the FASB established guidance under FASB ASC Paragraph 820-10-65-4, Determining Fair Value When the
Volume and Level of Activity for the Asset or Liability Have Significantly
Decreased and Identifying Transactions That Are Not Orderly (“FASB ASC
820-10-65-4”), which provides guidance on determining fair values for assets or
liabilities when there is no active market or where the price inputs being used
represent distressed sales. The guidance reaffirms the need to use judgment to
ascertain if a formerly active market has become inactive and determining fair
values when markets have become inactive. FASB ASC 820-10-65-4 became effective
for interim and annual reporting periods ending after June 15, 2009. Upon
adoption of FASB ASC 820-10-65-4 during the second quarter of 2009, there was no
material impact on the Company’s condensed consolidated financial
statements.





In April
2009, the FASB established guidance under FASB ASC Paragraph 320-10-65-1, Recognition and Presentation of
Other-Than-Temporary Impairments (“FASB ASC 320-10-65-1”), which amends
the other-than-temporary impairment guidance in U.S. GAAP for debt securities to
make the guidance more operational and to improve the presentation and
disclosure of other-than-temporary impairments on debt and equity securities in
the financial statements. FASB ASC 320-10-65-1 became effective for interim and
annual reporting periods ending after June 15, 2009 with early adoption
permitted for periods ending after March 15, 2009. Upon adoption of FASB ASC
320-10-65-1 during the second quarter of 2009, there was no material impact on
the Company’s condensed consolidated financial statements.





In April
2009, the FASB established guidance under FASB ASC Paragraph 825-10-65-1, Interim Disclosures about Fair Value
of Financial Instruments, (“FASB ASC 825-10-65-1”). FASB ASC 825-10-65-1
requires the disclosures of the fair value of financial instruments in
summarized financial information at interim reporting periods for publicly
traded companies as well as in annual financial statements. FASB ASC 825-10-65-1
became effective for interim and annual reporting periods ending after June 15,
2009. Upon adoption of FASB ASC 825-10-65-1 during the second quarter of 2009,
there was no material impact on the Company’s condensed consolidated financial
statements.





In May
2009, the FASB established guidance under FASB ASC Topic 855, Subsequent Events(“FASB ASC
855”), which establishes
general standards of accounting for and disclosure of events that occur after
the balance sheet date but before financial statements are issued or are
available to be issued. FASB ASC 855 became effective for interim
and annual reporting periods ending after June 15, 2009. The Company performed
an evaluation of subsequent events through November
4, 2009, and issued their financial statements on November
5, 2009.





In
September 2009, the FASB issued FASB Accounting Standard Update (“ASU”) 2009-13,
Multiple-Deliverable Revenue
Arrangements (“FASB ASU 2009-13”), which addresses
criteria for separating consideration in multiple-element arrangements. The
guidance requires companies allocating the overall consideration to each
deliverable to use an estimated selling price of individual deliverables in the
arrangement in the absence of vendor-specific objective evidence or other
third-party evidence of the selling price for the deliverables. FASB ASU 2009-13
will be effective for fiscal years beginning on or after June 15, 2010 and early
adoption is permitted. The Company has not determined the effect that the
adoption of this guidance will have on its condensed consolidated financial
statements.
 
 In
September 2009, the FASB issued FASB ASU 2009-14, Certain Revenue Arrangements that
Include Software Elements (“FASB ASU 2009-14”), which excludes from the
scope of the FASB’s software revenue guidance tangible products that contain
both software and non-software components that function together to deliver a
product’s essential functionality. FASB ASU 2009-14 will be effective
prospectively for revenue arrangements entered into or materially modified in
fiscal years beginning on or after June 15, 2010 with early adoption permitted.
If a company chooses to early adopt this guidance and the adoption is not at the
beginning of its fiscal year, the requirements must be applied retrospectively
to the beginning of the fiscal year. The Company has not determined the effect
that the adoption of this guidance will have on its condensed consolidated
financial statements.


3.
            FAIR
      VALUE MEASUREMENTS





FASB ASC
Topic 820, Fair Value Measurements and
Disclosures (“FASB ASC 820”), as amended, defines fair value as the
exchange price that would be received for an asset or paid to transfer a
liability (an exit price) in the principal or most advantageous market for the
asset or liability in an orderly transaction between market participants on the
measurement date. FASB ASC 820 also establishes a fair value hierarchy which
requires an entity to maximize the use of observable inputs and minimize the use
of unobservable inputs when measuring fair value. The standard describes the
following three levels of inputs that may be used to measure fair
value:





·
            Level 1 - Unadjusted
      quoted prices in active markets that are accessible at the measurement
      date for identical, unrestricted assets or
  liabilities.





·
            Level 2 - Observable
      inputs other than Level 1 prices such as quoted prices for similar assets
      or liabilities; quoted prices in markets that are not active; or other
      inputs that are observable or can be corroborated by observable market
      data for substantially the full term of the assets or
      liabilities.





·
            Level 3 - Unobservable
      inputs that are supported by little or no market activity and that are
      significant to the fair value of the assets or
  liabilities.





6





The
Company’s assets that are measured at fair value on a recurring basis are
generally classified within Level 1 or Level 2 of the fair value
hierarchy.  The types of instruments valued based on quoted market
prices in active markets include mostly money market securities and equity
investments.  Such instruments are generally classified within Level 1
of the fair value hierarchy.  The Company invests in money market
funds that are traded daily and does not adjust the quoted price for such
instruments.  The types of instruments valued based on quoted prices
in less active markets, broker or dealer quotations, or alternative pricing
sources with reasonable levels of price transparency include corporate notes,
commercial paper and certificates of deposits.  Such instruments are
generally classified within Level 2 of the fair value hierarchy.  The
Company uses consensus pricing, which is based on multiple pricing sources, to
value its fixed income investments.





The
following table sets forth a summary of the Company’s financial assets,
classified as cash and cash equivalents and short-term investments on its
condensed consolidated balance sheet, measured at fair value on a recurring
basis as of September 30, 2009 (in thousands):





Fair
      Value Measurements at
              Reporting
      Date UsingDescription
            
            Total
            
            
            Quoted
      Prices in
                Active
      Markets
                for
                Identical
      Assets
                (Level
      1)
            
            
            Significant
                Other
      Observable
                Inputs
                (Level
      2)
            
            
            Significant
                Unobservable
                Inputs
                (Level
      3)Cash
      & cash equivalents:Money
      Market Funds
            
            $
            16,523
            
            
            $
            16,523
            
            
            $
            --
            
            
            $
            --Corporate
      Notes
            
            
            790
            
            
            
            --
            
            
            
            790
            
            
            
            --Total
            
            $
            17,313
            
            
            $
            16,523
            
            
            $
            790
            
            
            $
            --Short-term
      investments:Corporate
      Notes
            
            $
            5,662
            
            
            $
            --
            
            
            $
            5,662
            
            
            $
            --Commercial
      Paper
            
            
            2,541
            
            
            
            --
            
            
            
            2,541
            
            
            
            --Agency
      Bond
            
            
            1,224
            
            
            
            --
            
            
            
            1,224
            
            
            
            --Total
            
            $
            9,427
            
            
            $
            --
            
            
            $
            9,427
            
            
            $
            --





4.
            NET
      INCOME PER SHARE





Basic net
income per share is calculated based on the weighted-average number of common
shares outstanding in accordance with FASB ASC Topic 260, Earnings per Share. Diluted
net income per share is calculated based on the weighted-average number of
common shares outstanding 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 stock options outstanding that would be
anti-dilutive. Potential common shares are composed of shares of common stock
issuable upon the exercise of stock options. The following table sets forth the
calculation of basic and diluted net income per share (in thousands, except per
share amounts):




Three
      Months Ended
                September
      30,
            
            
            Nine
      Months Ended
                September
      30,2009
            
            
            2008
            
            
            2009
            
            
            2008Net
      income, as reported (A)
            
            $
            2,803
            
            
            $
            924
            
            
            $
            6,123
            
            
            $
            2,886Weighted
      average shares of common stock outstanding (B)
            
            
            17,148
            
            
            
            17,976
            
            
            
            17,038
            
            
            
            17,969Dilutive
      effect of employee stock options
            
            
            1,338
            
            
            
            879
            
            
            
            1,087
            
            
            
            1,090Common
      stock and common stock equivalents (C)
            
            
            18,486
            
            
            
            18,855
            
            
            
            18,125
            
            
            
            19,059Net
      income per share:Basic
      (A/B)
            
            $
            0.16
            
            
            $
            0.05
            
            
            $
            0.36
            
            
            $
            0.16Diluted
      (A/C)
            
            
            0.15
            
            
            
            0.05
            
            
            
            0.34
            
            
            
            0.15





The
Company’s calculation of diluted net income per share for the three months ended
September 30, 2009 and 2008 excludes stock options to purchase approximately
768,000 and 1.6 million shares of the Company’s common stock, respectively, as
their effect would be anti-dilutive. The diluted net income per share for the
nine months ended September 30, 2009 and 2008 excludes stock options to purchase
approximately 1.1 million and 1.3 million shares of the Company’s common stock,
respectively, as their effect would be anti-dilutive.





7


5.
            STOCK-BASED
      COMPENSATION





Stock
Option Plans





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, as amended (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 by the Company’s
shareholders in May 2006, the Company may no longer make any grants under
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 forfeited, expired or cancelled are added to shares
available under the 2006 Plan. A maximum of 5,850,933 shares are available for
delivery under the 2006 Plan, which consists of (i) 2,150,000 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 May 18, 2006. 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 business day immediately preceding the date of grant.
Non-qualified stock options granted under the 2006 Plan have a term of six
years.





Stock
options granted by the Company are categorized into three types.  The
first type is performance-based stock options that are subject to cancellation
if the specified performance targets, as approved by the Company's Compensation
Committee, are not met.  If the applicable performance targets have
been achieved, the options will vest in four equal annual installments beginning
one year after the performance-related period has ended.  The fair
value of these stock 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 specified performance targets must be
met.




The
second type of stock options granted by the Company to certain employees and new
non-employee directors is non-performance-based stock options that are subject
only to time-based vesting.  These stock options vest in four equal
annual installments beginning one year after the grant date.  The fair
value of these 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.
 
 Commencing
in May 2009 the Company began granting its non-employee directors options
annually that are similar to the non-performance-based options described above
except the director options vest one year after the grant date. The fair value
of these option grants is determined on the date of the grant and the related
compensation expense is recognized over one year. Prior to May 2009 non-employee
directors received non-performance-based stock options that vested over four
years.


The plans
may be terminated by the Company’s Board of Directors at any time.





Stock-Based
Compensation Expense Information





The
following table summarizes the allocation of stock-based compensation expense
related to employee and director stock options under FASB ASC Topic 718, Compensation – Stock
Compensation  for the three and nine months ended September 30,
2009 and 2008 (in thousands):





Three
      Months Ended
                September
      30,
            
            
            Nine
      Months Ended
                September
      30,2009
            
            
            2008
            
            
            2009
            
            
            2008Stock-based
      compensation expense by category:Cost
      of services
            
            $
            71
            
            
            $
            13
            
            
            $
            186
            
            
            $
            154Sales
      and marketing
            
            
            352
            
            
            
            132
            
            
            
            890
            
            
            
            876Research
      and development
            
            
            254
            
            
            
            205
            
            
            
            726
            
            
            
            637General
      and administrative
            
            
            298
            
            
            
            89
            
            
            
            745
            
            
            
            648Total
      stock-based compensation expense
            
            $
            975
            
            
            $
            439
            
            
            $
            2,547
            
            
            $
            2,315





Valuation
Assumptions




The
Company estimated the fair value of stock options using the Black-Scholes
valuation model. There were no material changes in the way the assumptions
were calculated as previously disclosed in the Company’s Annual Report on Form
10-K for the year ended December 31, 2008.  The weighted-average
estimated per option value of performance-based, non-performance-based and
director options granted during the nine months ended September 30, 2009 and
September 30, 2008 used the following assumptions:





Nine
      Months Ended
              September
      30,
            
            
            Nine
      Months Ended
              September
      30,Valuation
      assumptions for performance-basedoptions:
            
            2009
            
            
            2008Dividend
      yield
            
            
            --
            
            
            
            --Expected
      volatility
            
            
            67.35
            
            
            
            63.66Risk-free
      interest rate
            
            
            1.77
            %
            
            
            2.39
            %Expected
      life of option (in years)
            
            
            4.75
            
            
            
            4.75




The
Company only granted performance-based options during the first quarter of 2009
and 2008 for the nine months ended September 30, 2009 and 2008.


8


Nine
      Months Ended
              September
      30,
            
            
            Nine
      Months Ended
              September
      30,Valuation
      assumptions for non-performance-basedoptions:
            
            2009
            
            
            2008Dividend
      yield
            
            
            --
            
            
            
            --Expected
      volatility
            
            
            67.88
      – 69.08
            
            
            
            63.21
      – 65.72Risk-free
      interest rate
            
            
            1.64
      – 2.36
            %
            
            
            2.22
      – 3.34
            %Expected
      life of option (in years)
            
            
            4.25
            
            
            
            4.25




Nine
      Months Ended
              September
      30,
            
            
            Nine
      Months Ended
              September
      30,Valuation
      assumptions for director annualoptions:
            
            2009
            
            
            2008Dividend
      yield
            
            
            --
            
            
            
            --Expected
      volatility
            
            
            71.48
            
            
            
            --Risk-free
      interest rate
            
            
            2.01
            %
            
            
            --Expected
      life of option (in years)
            
            
            3.50
            
            
            
            --


The
Company only granted annual director options during the second quarter of the
nine months ended September 30, 2009. No annual director options were granted
during the nine months ended September 30, 2008.






Stock
Option Activity





The
following table sets forth a summary of option activity for the nine months
ended September 30, 2009:




As
      of September 30, 2009Options
            
            
            Weighted-
                Average
                Exercise
                PriceBalances,
      beginning of year
            
            
            3,300,565
            
            
            $
            9.46Options
      granted
            
            
            566,375
            
            
            
            7.59Options
      exercised
            
            
            (269,824
            )
            
            
            6.70Options
      forfeited or expired
            
            
            (62,404
            )
            
            
            12.52Options
      outstanding
            
            
            3,534,712
            
            
            
            9.32Option
      price range
            
            $
            2.51
      – 50.50Weighted-average
      fair value of options granted
            
            $
            4.07Options
      exercisable
            
            
            2,230,697
            
            
            
            8.10Options
      available for grant
            
            
            866,994




6.
            CONCENTRATION
      OF CREDIT RISK





9





7.
            COMMITMENTS
      AND CONTIGENCIES





Legal
Proceedings





During
the fourth quarter of 2008, the Company reached a settlement with the French
Taxing Authority (“FTA”) as a result of a tax audit that had been conducted
encompassing the years 1998 through 2004.Subsequent to the
settlement, the Company received a letter from another division within the FTA
that claimed Interactive Intelligence France SARL owes $730,000 in penalties and
interest as of September 30, 2009. The Company has submitted an appeal for
this amount, as it believes that these penalties and interest were agreed to and
paid in the previous settlement. The Company does not believe it will have to
pay any money related to this claim; therefore, no amount has been accrued as of
September 30, 2009. Although the Company is appealing this claim, it cannot
provide assurance that these matters will be resolved without further litigation
or that the Company will not have to pay some or all of this
amount.





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





The
Company’s world headquarters are located in a 200,000 square foot space in two
office buildings in Indianapolis, Indiana. The Company leases the space under an
operating lease agreement and amendments which expire on March 31, 2018. The
Company also occupies a product distribution center in Indianapolis,
Indiana and three regional offices in the United States which are located
in Herndon, Virginia, Irvine, California and Columbia, South Carolina. The
Company also leases offices for each of its Europe, the Middle East and Africa
(“EMEA”) and Asia-Pacific (“APAC”) operations in Berkshire, United Kingdom and
Kuala Lumpur, Malaysia, respectively, and has several other office leases
throughout the United States and in 11 other countries. The Company rents office
space for sales, services, development and international offices under
month-to-month leases. In accordance with FASB ASC Topic 840, Leases, rental expense is
recognized ratably over the lease period, including those leases containing
escalation clauses.





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 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.





8.
            INCOME
      TAXES





The
following table is a reconciliation of the difference between the actual
provision for income taxes and the provision computed by applying the federal
statutory rate, 35%, on income before income taxes (in
thousands):





Three
      Months Ended
                September
      30,
            
            
            Nine
      Months Ended
                September
      30,2009
            
            
            2008
            
            
            2009
            
            
            2008Expected
      income tax expense at 35% tax rate
            
            $
            (1,674
            )
            
            $
            (568
            )
            
            $
            (3,705
            )
            
            $
            (1,824
            )State
      taxes, net of federal benefit
            
            
            (249
            )
            
            
            (81
            )
            
            
            (563
            )
            
            
            (261
            )Non-deductible
      stock-based compensation expense
            
            
            (147
            )
            
            
            (137
            )
            
            
            (395
            )
            
            
            (481
            )Research
      and experimentation tax credit
            
            
            63
            
            
            
            169
            
            
            
            189
            
            
            
            169Other
            
            
            2
            
            
            
            (82
            )
            
            
            (14
            )
            
            
            73Income
      tax expense
            
            $
            (2,005
            )
            
            
            (699
            )
            
            $
            (4,488
            )
            
            $
            (2,324
            )




Income Taxes





The
Company and its subsidiaries file federal income tax returns and income tax
returns in various states and foreign jurisdictions.  Tax years 2005
and forward remain open for examination for federal tax purposes and tax years
2004 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 carryforwards at December 31, 2008
will remain subject to examination until the respective tax year is
closed.





During
the second quarter of 2009, the Company utilized its remaining net operating
loss deferred tax asset generated in prior years and began utilizing operating
losses generated from tax benefits related to the exercise of stock options. The
Company does not have a deferred tax asset on its balance sheet for the tax
benefits from these deductions, and the reduction in taxes payable related to
the use of these deductions increases additional paid-in capital. At September
30, 2009, the Company had approximately $17.6 million in stock-based
compensation deductions available to offset taxable income and $4.7 million of
alternative minimum tax, federal and state research tax credit carryforwards and
foreign tax credits available to offset taxes payable. In addition, the Company
has a deferred tax asset of $348,000 available to offset future taxable income
of a subsidiary.


10


9.
            ACQUISITION





Stock
Purchase Agreement
 
 During
the second quarter of 2009, the Company entered into a stock purchase agreement
with AcroSoft Corp. (“AcroSoft”) pursuant to which the Company purchased 100% of
AcroSoft’s issued and outstanding shares of capital stock for an aggregate
purchase price of $2.4 million with cash available from operations. Ten percent
of the purchase price, or $240,000, was deposited into an escrow account to
ensure funds are available to pay indemnification claims, if any. AcroSoft’s
results of operations since the acquisition date, May 15, 2009, have been
included in the Company’s condensed consolidated statements of income for
the three and nine months ended September 30, 2009.
 
 The
preliminary purchase price allocations for the Company’s acquisition of AcroSoft
are based on a third-party valuation report which was prepared in accordance
with the provisions of FASB ASC
805and 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 the acquisition (in thousands):
 
 May
      15, 2009Cash
              
              $
              149Investments
              
              
              2Accounts
      receivable
              
              
              62Prepaid
      royalties
              
              
              30Other
      current assets
              
              
              1Property,
      plant and equipment
              
              
              26Current
      tax asset
              
              
              122Deferred
      tax asset
              
              
              287Accounts
      payable
              
              
              (8
              )Deferred
      tax liability
              
              
              (212
              )Intangible
      assets
              
              
              530Goodwill
              
              
              1,695Total
      assets acquired
              
              $
              2,684Deferred
      services revenue
              
              
              (284
              )Net
      assets acquired
              
              $
              2,400
  The fair
value of financial assets acquired includes accounts receivable with a fair and
contractual value of $62,000. The receivables consist of amounts due from
customers for products sold and/or services rendered.
 
 During the third quarter, the
Company finalized AcroSoft’s tax return for the period beginning January 1, 2009
and ending on the acquisition date of May 15, 2009.  As a result,
AcroSoft goodwill increased $61,000 from June 30, 2009 to September 30, 2009,
which is reflected in the Company’s deferred tax assets on the accompanying
condensed consolidated balance sheets.
 
 Acquisition-related
costs recognized as of September 30, 2009 include transaction costs such as
legal, accounting, valuation and other professional services, which were
expensed as incurred. Acquisition-related costs totaled $27,000 and $79,000 for
the three and nine months ended September 30, 2009, respectively. These costs
are included within general and administrative expenses on the condensed
consolidated statements of income for both periods.
 
 The
premium paid over the fair value of the net assets acquired in the purchase, or
goodwill, was primarily attributed to expected synergies from AcroSoft’s
document management software, experienced document management staff and an
existing client base. Included within goodwill is the assembled workforce,
comprised of 12 employees, which does not qualify for separate recognition. None
of the goodwill is expected to be deductible for tax purposes.
 
 Customer
relationships are amortized based upon patterns in which the economic benefits
are expected to be realized. Other finite-lived identifiable intangible assets
are amortized on a straight-line basis. The following are the identifiable
intangible assets acquired and their respective remaining economic useful
lives:
 
 Amount
              
              
              Remaining
      Economic Useful Life
                  (in
      years)Customer
      relationships
              
              $
              210,000
              
              
              
              6Core
      technology
              
              
              320,000
              
              
              
              5Total
              
              $
              530,000
 
 Goodwill
 
 Goodwill
is reviewed for impairment at least annually in accordance with the provisions
of FASB ASC Subtopic 350-20, Intangibles - Goodwill and
Other. 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). 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. 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 FASB ASC 805.
The residual fair value after this allocation is the implied fair value of the
reporting unit goodwill. The following table presents a rollforward of goodwill,
which is included within other assets, net on the accompanying condensed
consolidated balance sheets, as of September 30, 2009 (in
thousands):
 
 Balance
      as of January 1, 2009
              
              $
              995AcroSoft
      goodwill
              
              
              1,756Balance
      as of September 30, 2009
              
              $
              2,751
 
 11
 The
allocation of the purchase price is preliminary and is subject to finalization.
The Company plans to complete a research and development study during the fourth
quarter of 2009 for AcroSoft, which may result in a related research and
development credit recorded as a deferred tax asset. Adjustments for this tax
matter will result in a corresponding adjustment to recorded
goodwill.


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 our investors with an understanding
of our past performance, our financial condition and our 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 Part I, Item 1A “Risk Factors”
section of our Annual Report on Form 10-K for the fiscal year ended December 31,
2008. The following will be discussed and analyzed:





·    Forward-Looking
Information





·    Overview





·    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 (the “Exchange Act”)) 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, unstable economic conditions, rapid technological
changes in the industry, our ability to maintain profitability, to manage
successfully our growth, to manage successfully our increasingly complex
third-party relationships resulting from the software and hardware components
being licensed or sold with our solutions, to maintain successful relationships
with certain suppliers which may be impacted by competition in the technology
industry, to maintain successful relationships with our current and any new
partners, to maintain and improve our current products, to develop new products,
to protect our proprietary rights adequately, to successfully integrate
acquired businesses and other factors set forth in our Securities and
Exchange Commission (“SEC”) filings.





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. We
file annual, quarterly and current reports, proxy statements and other documents
with the SEC under the Exchange Act. These periodic and current reports and all
amendments to those reports are available free of charge on the investor
relations page of our website at http://investors.inin.com.





We are a
leading provider of software application suites for Voice over Internet Protocol
(“VoIP”) business communications, and are increasingly leveraging our leadership
position in the worldwide contact center market to offer our solutions for a
broad range of business operations. In addition to contact centers, our
solutions are used in various industries including, but not limited to,
teleservices, financial services, insurance, higher education, healthcare,
retail, technology, government and business services, including organizations
that employ remote and mobile workers. For enterprises that rely on the
Microsoft® Corporation (“Microsoft”) platform, we offer a pre-integrated
all-software Internet Protocol Private Branch Exchange phone and communications
system that enables straightforward integration to Microsoft compatible
applications for data management. In all, our innovative software products and
services are designed expressly for multichannel contact management, business
communications and messaging using the Session Initiation Protocol (“SIP”)
global communications standard that supports VoIP. To supplement our software
solutions, we also offer a media server, media gateways and SIP proxy for
IP-based communications networks and infrastructures. Our customers can deploy
our solutions as an on-premise system at their site or as Communications as a
Service (“CaaS”).





Our
application-based solutions are integrated on a single software platform.
Overall, our platform has been developed to deliver security, broaden
integration to business systems and end-user devices, enhance mobility for
today’s workforce, scale to thousands of users, and comprehensively address
various business communications and interaction management needs in markets
for:




·
            The
      Contact Center




·
            Enterprise
      IP Telephony




·
            Enterprise
      Messaging


12





By
implementing our all-in-one solutions, businesses are able to unify multichannel
communications media (phone, fax, e-mail and web chat); improve workforce
performance, effectiveness and productivity; and more readily adapt to changing
market and customer requirements. Organizations in the industries we serve are
further able to reduce equipment and maintenance costs over traditional
“multi-point” communications hardware, and additionally reduce the complexity of
such non-integrated systems.





For
further information on our business and the products and services we offer,
refer to the Part I, Item 1 “Business” section of our Annual Report on Form 10-K
for the year ended December 31, 2008.




We are
currently completing development of the first version of Interaction Process
Automation (“IPA”), an application which uses our communications-based platform
to automate business processes. The IPA module integrates to and leverages the
Interactive Intelligence Customer Interaction Center (“CIC”) platform to
automate business people-centric processes based on CIC’s multichannel
communications, queuing and routing capabilities. This communications-based
process automation approach enables IPA to capture, prioritize, route, escalate
and track each step of the process flow regardless of staff location. We are
targeting general distribution of IPA by or during the first quarter of
2010. The licensing of our CIC platform is typically under a perpetual license
resulting in product revenue for the license when revenue recognition criteria
are met. For IPA, we currently plan on licensing for an initial one year term
that will renew annually which will result in product revenue being recognized
ratably over the year. We do not anticipate recognizing any revenues from the
licensing of IPA until 2010.




Our
management monitors certain key measures to assess our financial results. In
particular, we track trends on product orders, contracted professional services,
and CaaS orders from quarter to quarter and in comparison to the prior year and
budget. Because salaries are our largest expense, we regularly monitor staffing
levels. As noted below, macroeconomic conditions have materially affected
the orders we received in recent quarters; therefore, we review leading market
indicators to look for trends in economic conditions. In addition to orders and
revenues, management reviews costs of revenue and operating expenses to ensure
we are managing new expenditures and controlling costs. Finally, management
monitors diluted earnings per share, which is a key measure of performance that
is also used by analysts and investors.


The table
below shows our total revenues (in millions) for the most recent five quarters
and the years ended December 31, 2008, 2007 and 2006 and the percentage change
over the previous period.





Period
            
            Revenues
            
            
            Sequential
              Growth %Three Months Ended:September
      30, 2009
            
            $
            33.2
            
            
            
            1
            %June
      30, 2009
            
            
            32.9
            
            
            
            12
            %March
      31, 2009
            
            
            29.5
            
            
            
            (6
            )%December
      31, 2008
            
            
            31.3
            
            
            
            4
            %September
      30, 2008
            
            
            30.1
            
            
            
            (2
            )%Year Ended December 31:2008
            
            $
            121.4
            
            
            
            10
            %2007
            
            
            109.9
            
            
            
            32
            %2006
            
            
            83.0
            
            
            
            32
            %





As shown in the 2008 annual
growth rate and the quarterly growth rates in 2008 and 2009, our revenue growth
trend has generally slowed, although we did experience significant increased
growth in the second quarter of 2009. We believe that these slower
growth rates are primarily due to the instability in the economy worldwide,
which has resulted in longer sales cycles, as prospects are hesitant to commit
to new capital purchases and many existing customers are delaying purchases of
additional software and hardware as they maintain or reduce staffing
levels.
 
 We will continue to
focus on maintaining profitability by continuing to increase the efficiency of
our sales and marketing efforts and by management of our operating expenses. As
our profitability allows, we will position the company for future growth through
increased investment in research and development.


Financial
Highlights





During
the three and nine months ended September 30, 2009, we experienced a decrease in
the dollar amount of license orders of 10% and 8%, respectively, compared to the
same periods in 2008. Although total license orders decreased, product revenue
increased by 6% and 1%, respectively, compared to the same periods in 2008 due
to a higher percentage of perpetual contracts, which can typically be recognized
immediately.  In addition, during the three months ended September 30, 2009
compared to the same period in 2008, we recognized more revenues related to
license orders that we had received in previous quarters but for which we had
originally deferred recognition because at least one of the revenue recognition
criteria had not been met.
 During
the three months ended September 30, 2009, we received orders for our CaaS
solutions for what is contracted to be at least $3.6 million in future
services revenues. The revenues from these orders will be recognized ratably
over the life of the CaaS contract, which is typically three to four years.
These orders represent a significant increase in CaaS contract amounts compared
to those we have received in previous periods. Although some costs related to
CaaS are fixed, others are variable based on usage and call volume, and
therefore, we would expect our services expenses to increase as the revenues
from these orders are recognized over the next three to four
years.
 
 Services
revenues increased by $2.2 million and $5.1 million during the three and nine
months ended September 30, 2009, respectively, compared to the same periods last
year, primarily due to increased support fees as our product revenues grew and
increased revenues from our CaaS related services.


13


Costs of
product increased during the three and nine months ended September 30, 2009
compared to the same periods in 2008 primarily as a result of an increase of
$248,000 and $1.6 million, respectively, in hardware and appliances included in
customer orders. Costs of services decreased for the three and nine months ended
September 30, 2009 compared to the same periods in 2008 by $510,000 and $1.3
million, respectively, primarily due to a decrease in compensation and travel
expenses, partially offset by an increase in CaaS related expenses.
 
 Total
operating expenses, which include sales and marketing, research and development
and general and administrative expenses, increased by $669,000, or 4%, for the
three months ended September 30, 2009 compared to the same period in 2008. Our
stock-based compensation expense increased for the three months ended September
30, 2009 in part due to a reduction in the forfeiture rate assumption that we
used in calculating the expense during the third quarter of 2009 based on recent
history, which resulted in an increase in compensation expense for all
departments during the quarter. Also impacting the quarter-over-quarter
stock-based compensation expense was the reversal of some performance-based
stock options in the third quarter of 2008, which reduced stock-based
compensation expense in 2008. Incentive expense also increased for the three
months ended September 30, 2009 as operating performance has improved and more
incentives were earned. Staffing increased in the sales and marketing and
research and development departments, which increased salary expense and general
allocable corporate expenses. Partially offsetting these increases, travel and
entertainment expenses as well as outsourced, professional and consulting
services decreased during the third quarter of 2009 due to continued cost
management reduction programs across all departments. Total operating expenses
decreased by $344,000, or 0.6%, for the nine months ended September 30,
2009.


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 nine months ended September
30, 2009 and 2008 are not necessarily indicative of the results that may be
expected for the full year or for any future period.


Three
      Months Ended
                  September
      30,
              
              
              Nine
      Months Ended
                September
      30,2009
              
              
              2008
              
              
              2009
              
              
              2008Revenues:Product
              
              
              47
              %
              
              
              49
              %
              
              
              47
              %
              
              
              50
              %Services
              
              
              53
              
              
              
              51
              
              
              
              53
              
              
              
              50Total
      revenues
              
              
              100
              
              
              
              100
              
              
              
              100
              
              
              
              100Cost
      of revenues:Product
              
              
              12
              
              
              
              12
              
              
              
              13
              
              
              
              12Services
              
              
              17
              
              
              
              20
              
              
              
              17
              
              
              
              20Total
      cost of revenues
              
              
              29
              
              
              
              32
              
              
              
              30
              
              
              
              32Gross
      profit
              
              
              71
              
              
              
              68
              
              
              
              70
              
              
              
              68Operating
      expenses:Sales
      and marketing
              
              
              29
              
              
              
              33
              
              
              
              30
              
              
              
              33Research
      and development
              
              
              18
              
              
              
              20
              
              
              
              18
              
              
              
              18General
      and administrative
              
              
              11
              
              
              
              11
              
              
              
              11
              
              
              
              12Total
      operating expenses
              
              
              58
              
              
              
              64
              
              
              
              59
              
              
              
              63Operating
      income
              
              
              13
              
              
              
              4
              
              
              
              10
              
              
              
              5Other
      income:Interest
      income, net
              
              
              --
              
              
              
              1
              
              
              
              --
              
              
              
              1Other
      income, net
              
              
              1
              
              
              
              --
              
              
              
              1
              
              
              
              --Total
      other income
              
              
              1
              
              
              
              1
              
              
              
              1
              
              
              
              1Income
      before income taxes
              
              
              14
              
              
              
              5
              
              
              
              11
              
              
              
              6Income
      tax expense
              
              
              (6
              )
              
              
              (2
              )
              
              
              (5
              )
              
              
              (3
              )Net
      income
              
              
              8
              %
              
              
              3
              %
              
              
              6
              %
              
              
              3
              %


14




Comparison
of Three and Nine Months Ended September 30, 2009 and 2008
 
 Revenues
 
 Product
      Revenues
                
                Three
      Months Ended
                    September
      30,
                
                
                Nine
      Months Ended
                    September
      30,2009
                
                
                2008
                
                
                2009
                
                
                2008($
      in thousands)Product
      revenues
                
                $
                15,557
                
                
                $
                14,687
                
                
                $
                45,100
                
                
                $
                44,853Change
      from prior year period
                
                
                6
                %
                
                
                (5
                )%
                
                
                1
                %
                
                
                6
                %Percentage
      of total revenues
                
                
                47
                %
                
                
                49
                %
                
                
                47
                %
                
                
                50
                %
 
 Product
revenues, which include software, hardware and appliance revenues, increased by
$870,000 during the three months ended September 30, 2009 compared to the same
period in 2008. Although total license dollar orders decreased by 10% compared
to the third quarter of 2008, product revenues increased by 6%. Perpetual
license orders, which can typically be immediately recognized, were 92% of total
license orders in the third quarter of 2009 compared to 84% in 2008. In
addition, we were able to recognize certain license orders which had been
received but not recognized in prior periods because all revenue recognition
criteria, primarily collectability, had not been
met.
 
 Product
revenues increased by $247,000 during the nine months ended September 30, 2009
compared to the same period in 2008. Although total license dollar orders
decreased by 8% compared to the nine months ended September 30, 2008, product
revenues increased by 1%. Perpetual license orders, which can typically be
immediately recognized, were 87% of total license orders in 2009 compared to 83%
in 2008. Additionally, we were able to recognize certain license orders during
the nine months ended September 30, 2009 which had been received but not
recognized in prior periods because all revenue recognition criteria, primarily
collectability, had not been met.
 Product
revenues can fluctuate from period to period depending on the mix of perpetual
and annually renewable licenses. The majority of our product licenses are
perpetual but we do also have certain customers, whose original license
contracts were signed prior to 2004, with renewable term licenses. Generally,
orders for perpetual licenses result in a significant portion of the contract
value being recognized when received if recognition criteria are satisfied,
while renewable term licenses are recognized ratably over the term of the
agreement, generally one year. The impact of the mix of contracts on our product
revenues occurs only in the year of a product order since fees from the
subsequent renewal of annually renewable licenses and renewal of support fees
for perpetual contracts are allocated entirely to services
revenues.
 Services
      Revenues
                
                Three
      Months Ended
                    September
      30,
                
                
                Nine
      Months Ended
                    September
      30,2009
                
                
                2008
                
                
                2009
                
                
                2008($
      in thousands)Services
      revenues
                
                $
                17,613
                
                
                $
                15,369
                
                
                $
                50,441
                
                
                $
                45,296Change
      from prior year period
                
                
                15
                %
                
                
                12
                %
                
                
                11
                %
                
                
                19
                %Percentage
      of total revenues
                
                
                53
                %
                
                
                51
                %
                
                
                53
                %
                
                
                50
                %
 
 Services
revenues include the portion of license arrangements allocated to maintenance
and support from annually renewable and perpetual contracts, renewals of
annually renewable licenses and maintenance contracts, as well as revenues from
professional services, CaaS and education.
 
 Services
revenues increased during the three and nine months ended September 30, 2009
compared to the same periods in 2008 primarily due to continued growth in the
number and size of our installed base of customers. Annual license renewal fees
and support fees for perpetual licenses, which comprise 77% of total services
revenues, increased by $1.7 million, or 15%, and $3.6 million, or 10%, during
the three months and nine months ended September 30, 2009, respectively,
compared to the same periods in 2008. We believe services revenues will continue
to grow as we continue to license and install our solutions to new customers and
expand existing customer implementations. The actual percentage fee charged for
the 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. Renewal rates for license and support fees have not
materially changed in 2009.
 CaaS
services increased by $338,000, or 75%, and $938,000, or 67%, during the three
and nine months ended September 30, 2009, respectively, compared to the same
periods in 2008, as more customers chose this hosted service solution. During
the third quarter of 2009, we received orders for our CaaS solutions for what is
contracted to be at least $3.6 million in future revenues that will be
recognized over the next three to four years. These orders did not have any
impact on revenues during the three or nine months ended September 30, 2009. We
believe our CaaS services revenues will continue to grow as more customers
utilize outsourced services for their information technology needs instead of
purchasing software and hardware and hiring additional technical
employees.
 15
 Cost
      of Revenues
                
                Three
      Months Ended
                    September
      30,
                
                
                Nine
      Months Ended
                    September
      30,2009
                
                
                2008
                
                
                2009
                
                
                2008($
      in thousands)Cost
      of revenues:Product
                
                $
                3,950
                
                
                $
                3,702
                
                
                $
                12,320
                
                
                $
                10,741Services
                
                
                5,549
                
                
                
                6,059
                
                
                
                16,758
                
                
                
                18,044Total
      cost of revenues
                
                $
                9,499
                
                
                $
                9,761
                
                
                $
                29,078
                
                
                $
                28,785Change
      from prior year period
                
                
                (3
                )%
                
                
                0
                %
                
                
                1
                %
                
                
                12
                %Product
      costs as a % of product revenues
                
                
                25
                %
                
                
                25
                %
                
                
                27
                %
                
                
                24
                %Services
      costs as a % of services revenues
                
                
                32
                %
                
                
                39
                %
                
                
                33
                %
                
                
                40
                %
 
 Costs of
product consist of hardware costs (including media servers and Interaction
Gateway appliances that we develop and servers, telephone handsets and gateways
that we purchase and resell), royalties for third party software and other
technologies included in our solutions, personnel costs, and software packaging
costs (including product media and documentation duplication).  Costs
of product can fluctuate depending on which software applications are licensed
to our customers and partners, the third party software that is licensed by the
end user from us as part of our software applications and the dollar amount of
orders for hardware and appliances.Costs of product increased
by $248,000 and $1.6 million, respectively, during the three and nine months
ended September 30, 2009 compared to the same periods in 2008, as more customers
included our hardware offerings in their implementations of our
solutions.
 
 Costs of
services consist primarily of compensation expenses for technical support,
professional services and educational personnel and costs associated with our
CaaS offering. These expenses decreased primarily due to reduced
compensation expense of $301,000 and $992,000, respectively, during the three
and nine months ended September 30, 2009 compared to the same periods in 2008 as
a result of a 7% reduction in services staff. In addition, travel related
expenses decreased by $233,000 and $701,000, respectively, as a result
of the reductions in services staff. Partially offsetting these
decreases were increases of $236,000 and $389,000, respectively, in CaaS
expenses primarily related to data center and associated hosting costs. We
believe CaaS expenses will continue to increase as our CaaS business
grows.
 Gross
      Profit
                    
                    Three
      Months Ended
                        September
      30,
                    
                    
                    Nine
      Months Ended
                        September
      30,2009
                    
                    
                    2008
                    
                    
                    2009
                    
                    
                    2008($
      in thousands)Gross
      profit
                    
                    $
                    23,671
                    
                    
                    $
                    20,295
                    
                    
                    $
                    66,463
                    
                    
                    $
                    61,364Change
      from prior year period
                    
                    
                    17
                    %
                    
                    
                    4
                    %
                    
                    
                    8
                    %
                    
                    
                    12
                    %Percentage
      of total revenues
                    
                    
                    71
                    %
                    
                    
                    68
                    %
                    
                    
                    70
                    %
                    
                    
                    68
                    %Product
      costs as a % of gross profit
                    
                    
                    17
                    %
                    
                    
                    18
                    %
                    
                    
                    19
                    %
                    
                    
                    18
                    %Services
      costs as a % of gross profit
                    
                    
                    23
                    %
                    
                    
                    30
                    %
                    
                    
                    25
                    %
                    
                    
                    29
                    %
  Gross
profit as a percentage of total revenues in any particular quarter is dependent
upon product and services revenues recognized versus costs of product and costs
of services incurred.
 Operating
Expenses
 Sales
      and Marketing
                
                Three
      Months Ended
                    September
      30,
                
                
                Nine
      Months Ended
                    September
      30,2009
                
                
                2008
                
                
                2009
                
                
                2008($
      in thousands)Sales
      and marketing expenses
                
                $
                9,696
                
                
                $
                9,547
                
                
                $
                28,877
                
                
                $
                29,870Change
      from prior year period
                
                
                2
                %
                
                
                3
                %
                
                
                (3
                )%
                
                
                12
                %Percentage
      of total revenues
                
                
                29
                %
                
                
                32
                %
                
                
                30
                %
                
                
                33
                %Percentage
      of net product revenues
                
                
                84
                %
                
                
                87
                %
                
                
                88
                %
                
                
                88
                %
 
 Sales and
marketing expenses primarily include compensation, travel, and promotional costs
related to our sales, marketing and channel management operations. These
expenses increased by $149,000 during the three months ended September 30, 2009
compared to the same quarter last year due to increases in commissions and
incentives resulting from the increased revenues during the quarter. Stock-based
compensation expense also increased compared to the third quarter of 2008 in
part due to a reduction in the forfeiture rate assumption that we used in
calculating the expense during the third quarter of 2009 based on recent history
and in part due to the reversal of some performance-based stock options in the
third quarter of 2008, which reduced the expense in 2008. Partially offsetting
these increases were decreases in reimbursements to our partners for their
marketing efforts and fees paid to third parties for customer
referrals.
 
 During
the nine months ended September 30, 2009 compared to the nine months ended
September 30, 2008, sales and marketing expenses decreased by $993,000 due to
reduced travel expenses of $662,000, reduced corporate marketing costs of
$322,000 and a decrease in outsourced services of $241,000. Referral fees also
decreased by $227,000 because fewer payments were made to third parties for
customer referrals. Partially offsetting these decreases was an increase in
compensation expense of $498,000 due primarily to increased incentives resulting
from the increased revenues during 2009. We expect marketing costs to increase
in future quarters.
 16
 Research
      and Development
                
                Three
      Months Ended
                    September
      30,
                
                
                Nine
      Months Ended
                    September
      30,2009
                
                
                2008
                
                
                2009
                
                
                2008($
      in thousands)Research
      and development expenses
                
                $
                6,135
                
                
                $
                5,801
                
                
                $
                17,747
                
                
                $
                16,102Change
      from prior year period
                
                
                6
                %
                
                
                33
                %
                
                
                10
                %
                
                
                29
                %Percentage
      of total revenues
                
                
                18
                %
                
                
                19
                %
                
                
                19
                %
                
                
                18
                %
 Research
and development expenses are comprised primarily of compensation costs,
depreciation, and allocated general corporate expense. Research and
development expenses increased by $334,000 during the three months ended
September 30, 2009 compared to the same period in 2008 primarily due to an
increase in compensation expense of $317,000, as a result of an 8% staffing
increase in the research and development department. The staffing increase was
the result of the AcroSoft acquisition in the second quarter of 2009 and other
research and development staffing additions.
 
 During
the nine months ended September 30, 2009 compared to the same period in 2008,
research and development expense increased by $1.6 million, primarily due to a
$1.2 million increase in compensation expense resulting from the increase in
staffing in the research and development department. In addition, allocable
corporate expenses increased by $633,000 due to the staffing additions in the
research and development department.
 
 We
believe that investment in research and development is critical to our future
growth and competitive position in the marketplace and is directly related to
timely development of new and enhanced solutions that are central to our
business. As a result, we expect research and development expenses will continue
to increase in future periods.
 General
      and Administrative
                
                Three
      Months Ended
                    September
      30,
                
                
                Nine
      Months Ended
                    September
      30,2009
                
                
                2008
                
                
                2009
                
                
                2008($
      in thousands)General
      and administrative expenses
                
                $
                3,562
                
                
                $
                3,376
                
                
                $
                10,166
                
                
                $
                11,162Change
      from prior year period
                
                
                5
                %
                
                
                2
                %
                
                
                (9
                )%
                
                
                16
                %Percentage
      of total revenues
                
                
                11
                %
                
                
                11
                %
                
                
                11
                %
                
                
                12
                %
  General
and administrative expenses include salary and incentive compensation expense as
well as general corporate expenses that are not allocable to other departments,
such as legal and other professional fees and bad debt expense.
 
 During
the three months ended September 30, 2009, these expenses increased by $186,000
compared to the same quarter last year. Total incentive expense increased by
$283,000 due to executive performance bonuses anticipated to be achieved at
year-end, which were not achieved during the same period in 2008. Stock-based
compensation expense also increased by $210,000, in part due to a reduction
in the forfeiture rate assumption that we used to calculate the expense
during the third quarter of 2009 and in part due to the reversal of some
performance-based stock options in the third quarter of 2008, which reduced the
expense in 2008. Partially offsetting the increases in incentive and
compensation expenses was a decrease in bad debt expense of $100,000 as well as
a $143,000 decrease in salary expense resulting from a 6% decrease in general
and administrative staffing.
 
 During
the nine months ended September 30, 2009, general and administrative expenses
decreased by $996,000 compared to the nine months ended September 30, 2008. This
decrease was due to reductions in salary expense of $546,000 due to a decreased
number of staff, travel and entertainment expense of $213,000, consulting,
outsourced and professional services costs of $126,000 and bad debt expense of
$197,000. Partially offsetting these decreases was an increase in incentive
expense of $536,000 due to anticipated achievement of general and administrative
executive bonuses.
 Other
Income (Expense)
 
 Interest
      Income
                
                Three
      Months Ended
                    September
      30,
                
                
                Nine
      Months Ended
                    September
      30,2009
                
                
                2008
                
                
                2009
                
                
                2008($
      in thousands)Cash,
      cash equivalents and short-term investments (average)
                
                $
                57,031
                
                
                $
                49,486
                
                
                $
                52,760
                
                
                $
                47,824Interest
      income
                
                
                51
                
                
                
                329
                
                
                
                232
                
                
                
                1,132Return
      on investment (annualized)
                
                
                0.36
                %
                
                
                2.66
                %
                
                
                0.59
                %
                
                
                3.16
                %
 
 Interest
earned on investments decreased during the three and nine months ended September
30, 2009, compared to the same periods in 2008, due to lower interest rates. We
continue to monitor the allocation of funds in which we have invested to
maximize our return on investment while utilizing safe investment alternatives
within our established investment policy.
 
 17
 Other Income (Expense),
      Net
                
                Three
      Months Ended
                    September
      30,
                
                
                Nine
      Months Ended
                    September
      30,2009
                
                
                2008
                
                
                2009
                
                
                2008($
      in thousands)Other
      income (expense), net
                
                $
                480
                
                
                $
                (277
                )
                
                $
                706
                
                
                $
                (152
                )
 
 Other
income (expense), net includes foreign currency transaction gains and losses.
Effective April 1, 2009, we changed our reporting to present gains and losses
resulting from foreign currency fluctuations in this category rather than within
operating expense because such gains and losses are incidental to our
operations. Foreign currency transaction gains and losses can fluctuate based on
the amount of revenue that is generated in certain international currencies,
particularly the Euro, the exchange gain or loss that results from foreign
currency disbursements and receipts and the cash balances and exchange rates as
of the end of a reporting period. In 2008, these amounts included foreign
withholding expenses that were later reclassified in the third quarter of 2008
as a result of a study of our foreign tax withholdings, which determined that we
had sufficient and appropriate foreign source income to record our foreign
withholdings as a tax credit instead of a deduction to taxable
income.
 
 During
the three months ended September 30, 2008, we recorded a loss from foreign
currency transactions of $458,000 and a gain of $181,000 related to foreign tax
withholding. For the first nine months of 2008, we recorded a loss from foreign
currency transactions of $119,000 and expense of $33,000 related to foreign tax
withholdings.
 
 Income
      tax expense
                
                Three
      Months Ended
                    September
      30,
                
                
                Nine
      Months Ended
                    September
      30,2009
                
                
                2008
                
                
                2009
                
                
                2008($
      in thousands)Income
      tax expense
                
                $
                2,005
                
                
                $
                699
                
                
                $
                4,488
                
                
                $
                2,324
 
 For the three and nine months
ended September 30, 2009, $92,000 and $232,000, respectively, of the income tax
expense is expected to result in cash payments and the remaining amount was
offset by the utilization of our net operating losses. We have significant
remaining credits and losses to offset taxable income and taxes payable as
described in Note 8 of Notes to Condensed Consolidated Financial Statements in
Part I, Item 1 of this Quarterly Report on Form 10-Q. Our effective tax rate was
42% as of September 30, 2009. The tax rate is determined by considering the
federal tax rate, rates in various states and international jurisdictions in
which we have operations, and the amount of the stock-based compensation
that is not deductible for income tax purposes.
 
 Liquidity
and Capital Resources
 
 We
generate cash from the collections related to licensing our products and from
annual license renewals, maintenance and support and other services revenues. We
use cash primarily for paying our employees (including salaries, commissions and
benefits), leasing office space, paying travel expenses and marketing
activities, paying vendors for hardware, other services and supplies, and
purchasing property and equipment. During the last six months of 2008, we
repurchased $10.0 million of our common stock, and during the second quarter of
2009, we acquired AcroSoft for $2.4 million. We continue to be debt
free.
 
 We
determine liquidity by combining cash and cash equivalents and short-term
investments as shown in the table below. Based on our recent performance and
current expectations, we believe that our current liquidity position, when
combined with our anticipated cash flows from operations, will be sufficient to
satisfy our working capital needs and current or expected obligations associated
with our operations over the next 12 months. Our future requirements will depend
on many factors, including cash flows from operations, territory expansion and
product development decisions and potential acquisitions. If our liquidity is
not sufficient to cover our needs, we may be forced to raise additional capital,
either through the capital markets or debt financings, and may not be able to do
so on favorable terms or at all.
 
 Our
liquidity position at September 30, 2009 and December 31, 2008 was as
follows:
 
 September
      30,
                
                
                December
      31,2009
                
                
                2008($
      in thousands)Cash
      and cash equivalents
                
                $
                50,584
                
                
                $
                34,705Short-term
      investments
                
                
                9,427
                
                
                
                10,805Liquidity,
      net
                
                $
                60,010
                
                
                $
                45,510
 18





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





The
following table shows the total increase from cash and cash equivalents from
operating activities, investing activities and financing activities for the
stated periods:





Nine
      Months Ended September 30,2009
            
            
            2008($
      in thousands)Cash
      provided by operating activities
            
            $
            13,038
            
            
            $
            11,405Cash
      used in investing activities
            
            
            (1,974
            )
            
            
            (4,026
            )Cash
      provided by (used in) financing activities
            
            
            4,815
            
            
            
            (2,262
            )Total
      increase in cash and cash equivalents
            
            $
            15,879
            
            
            $
            5,117





Operating
cash was generated primarily by our profitability and balance sheet management.
The cash used for capital purchases decreased during 2009. Cash provided by
financing activities increased primarily due to an increase in proceeds from
stock options exercised and no repurchases of our common stock in 2009 compared
to stock repurchases totaling $3.4 million in
2008.


As
of September 30, 2009, there have been no material changes in our
contractual obligations as set forth in the Contractual Obligations table
disclosed in our Annual Report on Form 10-K for the year ended December 31,
2008.





Off-Balance
Sheet Arrangements





Except as
set forth in the Contractual Obligations table disclosed in our Annual Report on
Form 10-K for the year ended December 31, 2008, we have no off-balance sheet
arrangements that have or are reasonably likely to have a current or future
material impact on our financial condition, changes in financial condition,
revenues or expenses, results of operations, liquidity, capital expenditures or
capital resources as of September 30, 2009.




We provide indemnifications of varying scope and amount to certain customers
against claims of intellectual property infringement made by third parties
arising from the use of our products. Our direct software license agreements, in
accordance with FASB ASC Topic 952, Franchisors, include certain
provisions for indemnifying customers, in material compliance with their license
agreement, against liabilities if our software products infringe upon a third
party's intellectual property rights, over the life of the agreement. There is
no maximum potential amount of future payments set under the guarantee. However,
we may at any time and at our option and expense:  (i) procure the right of
the customer to continue to use our software that may infringe a third party’s
rights; (ii) modify our software so as to avoid infringement; or (iii) require
the customer to return our software and refund the customer the fee actually
paid by the customer for our software less depreciation based on a five-year
straight-line depreciation schedule. The customer’s failure to provide
timely notice or reasonable assistance will relieve us of our obligations under
this indemnification to the extent that we have been actually and materially
prejudiced by such failure. To date, we have not incurred, nor do we expect to
incur, any material related costs and therefore have not reserved for such
liabilities.




Our
direct software license agreements also include a warranty that our software
products will substantially conform to our software user documentation for a
period of one year, provided the customer is in material compliance with the
software license agreement. To date, we have not incurred any material costs
associated with these product warranties, and as such, we have not reserved for
any such warranty liabilities in our operating results.




Critical
Accounting Policies and Estimates





The
preparation of our condensed consolidated financial statements requires us to
make estimates and judgments that affect the reported amount of assets,
liabilities, revenues and expenses. Actual results may differ from those
estimates and judgments under different assumptions or conditions. We have
discussed the critical accounting policies that we believe affect our more
significant estimates and judgments used in the preparation of our consolidated
financial statements in the “Management’s Discussion and Analysis of Financial
Condition and Results of the Operations—Critical Accounting Policies and
Estimates” section of our Annual Report on Form 10-K for the year ended December
31, 2008 and in Note 2 of Notes to Consolidated Financial Statements included in
our Annual Report on Form 10-K for the year ended December 31, 2008. For a
further summary of certain accounting policies, see Note 2 of Notes to Condensed
Consolidated Financial Statements included in Part I, Item 1 of this Quarterly
Report on Form 10-Q.





19




Item 3.
            Quantitative
      and Qualitative Disclosures about Market
Risk.





We
develop software application products in the United States and license our
products worldwide. As a result, our financial results could be affected by
market risks, including changes in foreign currency exchange rates, interest
rates or weak economic conditions in certain markets. Market risk is the
potential of loss arising from unfavorable changes in market rates and
prices.





Foreign
Currency Exchange Rates





We
transact business in certain foreign currencies including the British pound and
the Euro. However, as a majority of the orders we receive are denominated in
United States dollars, a strengthening of the dollar could make our products
more expensive and less competitive in foreign markets. We have not historically
used foreign currency options or forward contracts to hedge our currency
exposures because of variability in the timing of cash flows associated with our
larger contracts. We did not have any such hedge instruments in place at
September 30, 2009. Rather, we attempt to mitigate our foreign currency risk by
generally transacting business and paying salaries in the functional currency of
each of the major countries in which we do business, thus creating natural
hedges. Additionally, as our business matures in foreign markets, we may offer
our products and services in certain other local currencies. If this were to
occur, foreign currency fluctuations would have a greater impact on us and may
have an adverse effect on our results of operations. Historically, our gains or
losses on foreign currency exchange transactions have been immaterial to our
consolidated financial statements. For the three and nine months
ended September 30, 2009, our foreign currency exchange transaction gains
amounted to$477,000
and $709,000, respectively.





As of
September 30, 2009 and December 31, 2008, we had Euro balances of approximately
$14.0 million and $905,000, respectively, British pound balances of $317,000 and
$450,000, respectively, and balances of seven other foreign
currencies totaling $505,000 and $159,000,
respectively.





Interest
Rate Risk





We invest
cash balances in excess of operating requirements in securities that have
maturities of one year or less. The carrying value of these securities
approximates market value, and there is no long-term interest rate risk
associated with these investments.





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 Exchange Act is (a) recorded, processed, summarized and reported within the
time periods specified in the SEC’s rules and forms; and (b) accumulated and
communicated to our management, including our principal executive and principal
financial officers, to allow timely decisions regarding required disclosures. 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 September 30, 2009 pursuant to Rule 13a-15 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 as of September 30, 2009.





There
have been no changes in our internal control over financial reporting that
occurred during the three months ended September 30, 2009 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 under “Legal Proceedings” in Note 7 of Notes to Condensed
Consolidated Financial Statements included in Part I, Item 1 of this Quarterly
Report on Form 10-Q is incorporated herein by reference.





Item 1A.
            Risk
      Factors.





In
addition to the information set forth in this Quarterly Report on Form 10-Q 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 Part I, Item 1A “Risk
Factors” in our Annual Report on Form 10-K for the year ended December 31, 2008.
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. There have been no
material changes from the risk factors previously disclosed in our Annual Report
on Form 10-K for the year ended December 31, 2008.





20





Item
      6.
            Exhibits.





(a)
            Exhibits





Incorporated
      by ReferenceExhibit
      Number
            
            Exhibit
      Description
            
            Form
            
            Exhibit
            
            Filing
      Date
            
            Filed
      Herewith3.1
            
            Restated
      Articles of Incorporation of the Company, as currently in
      effect
            S-1
              (Registration
      No. 333-79509)
            
            3.1
            
            5/28/19993.2
            
            Amended
      By-Laws of the Company, as currently in effect
            
            8-K
            
            3.2
            
            7/28/200931.1
            
            Certification
      of the Chief Executive Officer pursuant to Rule 13a-14(a)/15d-14(a) of the
      Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the
      Sarbanes-Oxley Act of 2002
            
            
            
            
            
            
            X31.2
            
            Certification
      of the Chief Financial Officer pursuant to Rule 13a-14(a)/15d-14(a) of the
      Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the
      Sarbanes-Oxley Act of 2002
            
            
            
            
            
            
            X32.1
            
            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
      2002
            
            
            
            
            
            
            X32.2
            
            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
            
            
            
            
            
            
            X


21


SIGNATURE





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:   November
      6, 2009
            
            
            
            By:
            
            /s/     Stephen R.
      HeadStephen
      R. Head
              Chief
      Financial Officer,
              Vice
      President of Finance and Administration,
              Secretary
      and Treasurer
              (Principal
      Financial Officer and Principal Accounting Officer)


22