**UNITED
      STATES**


**SECURITIES
      AND EXCHANGE COMMISSION**





**Washington,
      D.C. 20549**





**____________**





**FORM
      10-Q**


**(Mark
      One)**





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





**For
      the quarterly period ended September 30, 2006**





**Or**





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





**For
      the transition period from ____________to____________**





**Commission
      File Number 000-27385**










**INTERACTIVE
      INTELLIGENCE, INC.**


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





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





**7601
      Interactive Way**


**Indianapolis,
      Indiana 46278**


**(Address
      of principal executive offices)**





**(317)
      872-3000**


**(Registrant's
      telephone number)**





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




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





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





The
      number of shares of common stock outstanding on October 31, 2006 was 16,849,494.















TABLE
      OF
      CONTENTS








PART
      I.
      FINANCIAL INFORMATION





Item
                1.
            Condensed
                Consolidated Balance Sheets as of September 30, 2006 and December
                31,
                2005
            1Condensed
                Consolidated Statements of Income for the three and nine months ended
                September 30, 2006 and 2005
            2Condensed
                Consolidated Statement of Shareholders’ Equity for the nine months ended
                September 30, 2006
            3Condensed
                Consolidated Statements of Cash Flows for the nine months ended September
                30, 2006 and 2005
            4Notes
                to Condensed Consolidated Financial Statements
            5Item
                2.
            Management's
                Discussion and Analysis of Financial Condition and Results of
                Operations
            11Item
                3.
            Quantitative
                and Qualitative Disclosures About Market Risk
            22Item
                4.
            Controls
                and Procedures
            22PART
                II. OTHER INFORMATIONItem
                1.
            Legal
                Proceedings
            23Item
                1A.
            Risk
                Factors
            23Item
                6.
            Exhibits
            23SIGNATURES
            24











**PART
      I. FINANCIAL INFORMATION**





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





**Interactive
      Intelligence, Inc.**


**Condensed
      Consolidated Balance Sheets**


**As
      of September 30, 2006 and December 31, 2005**


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





**September
                30,**
              **2006**
            
            **December
                31,**
              **2005****(unaudited)**
            
            **(Note
                1)****Assets**Current
                assets:Cash
                and cash equivalents
            
            $
            13,007
            
            $
            11,551Short-term
                investments
            
            
            9,333
            
            
            3,576Accounts
                receivable, net of allowance for doubtful accounts of $565 in 2006
                and
                $652 in 2005
            
            
            18,975
            
            
            14,927Deferred
                tax assets, net
            
            
            1,314
            
            
            --Prepaid
                expenses
            
            
            4,672
            
            
            2,939Other
                current assets
            
            
            860
            
            
            789Total
                current assets
            
            
            48,161
            
            
            33,782Property
                and equipment, net
            
            
            4,548
            
            
            4,013Deferred
                tax assets, net
            
            
            3,686
            
            
            --Other
                assets, net
            
            
            683
            
            
            603Total
                assets
            
            $
            57,078
            
            $
            38,398**Liabilities
                and Shareholders’ Equity**Current
                liabilities:Accounts
                payable and accrued liabilities
            
            $
            7,650
            
            $
            6,676Accrued
                compensation and related expenses
            
            
            2,278
            
            
            1,906Deferred
                product revenues
            
            
            5,496
            
            
            5,195Deferred
                services revenues
            
            
            21,156
            
            
            16,828Total
                current liabilities
            
            
            36,580
            
            
            30,605Shareholders’
                equity:Preferred
                stock, no par value: 10,000,000 authorized; no shares issued and
                outstanding
            
            
            --
            
            
            --Common
                stock, $0.01 par value: 100,000,000 authorized; 16,645,404 issued
                and
                outstanding at September 30, 2006, 16,120,543 issued and outstanding
                at
                December 31, 2005
            
            
            166
            
            
            161Additional
                paid-in capital
            
            
            69,834
            
            
            65,826Accumulated
                deficit
            
            
            (49,502
            )
            
            (58,194
            )Total
                shareholders’ equity
            
            
            20,498
            
            
            7,793Total
                liabilities and shareholders’ equity
            
            $
            57,078
            
            $
            38,398





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, 2006 and
      2005**


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





**Three
                Months Ended**
              **September
                30,**
            
            **Nine
                Months Ended**
              **September
                30,****2006**
            
            **2005**
            
            **2006**
            
            **2005**Revenues:Product
            
            $
            12,143
            
            $
            7,783
            
            $
            30,590
            
            $
            24,265Services
            
            
            10,030
            
            
            7,405
            
            
            28,766
            
            
            21,138Total
                revenues
            
            
            22,173
            
            
            15,188
            
            
            59,356
            
            
            45,403Cost
                of revenues:Product
            
            
            2,707
            
            
            963
            
            
            6,073
            
            
            2,837Services
            
            
            3,950
            
            
            2,743
            
            
            10,409
            
            
            8,153Total
                cost of revenues
            
            
            6,657
            
            
            3,706
            
            
            16,482
            
            
            10,990Gross
                profit
            
            
            15,516
            
            
            11,482
            
            
            42,874
            
            
            34,413Operating
                expenses:Sales
                and marketing
            
            
            7,694
            
            
            6,188
            
            
            21,428
            
            
            18,188Research
                and development
            
            
            3,414
            
            
            3,061
            
            
            9,676
            
            
            9,468General
                and administrative
            
            
            2,739
            
            
            2,153
            
            
            8,106
            
            
            6,209Total
                operating expenses
            
            
            13,847
            
            
            11,402
            
            
            39,210
            
            
            33,865Operating
                income
            
            
            1,669
            
            
            80
            
            
            3,664
            
            
            548Other
                income (expense):Interest
                income, net
            
            
            162
            
            
            69
            
            
            382
            
            
            182Other
                expense, net
            
            
            (25
            )
            
            (74
            )
            
            (89
            )
            
            (256
            )Total
                other income (expense)
            
            
            137
            
            
            (5
            )
            
            293
            
            
            (74
            )Income
                before income taxes
            
            
            1,806
            
            
            75
            
            
            3,957
            
            
            474Income
                tax benefit (expense)
            
            
            4,912
            
            
            (47
            )
            
            4,735
            
            
            (131
            )Net
                income
            
            $
            6,718
            
            $
            28
            
            $
            8,692
            
            $
            343Net
                income per share:Basic
            
            $
            0.40
            
            $
            0.00
            
            $
            0.53
            
            $
            0.02Diluted
            
            
            0.36
            
            
            0.00
            
            
            0.48
            
            
            0.02Shares
                used to compute net income per share:Basic
            
            
            16,626
            
            
            16,054
            
            
            16,438
            
            
            16,009Diluted
            
            
            18,545
            
            
            16,928
            
            
            18,010
            
            
            16,730








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, 2006**


**(in
      thousands)**





**Common
                Stock**
            
            **Additional**
              **Paid-in**
            
            **Accumulated****Shares**
            
            **Amount**
            
            **Capital**
            
            **Deficit**
            
            **Total**Balances,
                December 31, 2005
            
            
            16,121
            
            $
            161
            
            $
            65,826
            
            $
            (58,194
            )
            $
            7,793Issuances
                of common stock
            
            
            20
            
            
            --
            
            
            138
            
            
            --
            
            
            138Exercise
                of stock options
            
            
            504
            
            
            5
            
            
            2,253
            
            
            --
            
            
            2,258Stock-based
                compensation
            
            
            --
            
            
            --
            
            
            1,617
            
            
            --
            
            
            1,617Net
                income
            
            
            --
            
            
            --
            
            
            --
            
            
            8,692
            
            
            8,692Balances,
                September 30, 2006
            
            
            16,645
            
            $
            166
            
            $
            69,834
            
            $
            (49,502
            )
            $
            20,498





See
      Accompanying Notes to Condensed Consolidated Financial Statements





3








**Interactive
      Intelligence, Inc.**


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


**For
      the Nine Months Ended September 30, 2006 and 2005**


**(in
      thousands)**





**Nine
                Months Ended**
              **September
                30,****2006**
            
            **2005****Operating
                activities:**Net
                income
            
            $
            8,692
            
            $
            343Adjustments
                to reconcile net income to net cash provided by operating
                activities:Depreciation
            
            
            1,327
            
            
            1,625Accretion
                of investment income
            
            
            (51
            )
            
            --Stock-based
                compensation expense related to stock options
            
            
            1,617
            
            
            70Deferred
                income tax
            
            
            (5,000
            )
            
            --Loss
                on disposal of fixed assets
            
            
            4
            
            
            --Changes
                in operating assets and liabilities:Accounts
                receivable
            
            
            (4,048
            )
            
            (4,596
            )Prepaid
                expenses
            
            
            (1,733
            )
            
            (248
            )Other
                current assets
            
            
            (71
            )
            
            281Other
                assets
            
            
            (80
            )
            
            26Accounts
                payable and accrued liabilities
            
            
            974
            
            
            (650
            )Accrued
                compensation and related expenses
            
            
            372
            
            
            457Deferred
                product revenues
            
            
            301
            
            
            (109
            )Deferred
                services revenues
            
            
            4,328
            
            
            2,921Net
                cash provided by operating activities
            
            
            6,632
            
            
            120**Investing
                activities:**Purchases
                of property and equipment
            
            
            (1,866
            )
            
            (1,522
            )Purchases
                of available-for-sale investments
            
            
            (10,895
            )
            
            --Sales
                of available-for-sale investments
            
            
            5,189
            
            
            --Net
                cash used in investing activities
            
            
            (7,572
            )
            
            (1,522
            )**Financing
                activities:**Proceeds
                from issuance of common stock
            
            
            138
            
            
            165Proceeds
                from stock options exercised
            
            
            2,258
            
            
            326Net
                cash provided by financing activities
            
            
            2,396
            
            
            491Net
                increase (decrease) in cash and cash equivalents
            
            
            1,456
            
            
            (911
            )Cash
                and cash equivalents, beginning of period
            
            
            11,551
            
            
            14,603Cash
                and cash equivalents, end of period
            
            $
            13,007
            
            $
            13,692Cash
                paid for interest
            
            $
            46
            
            $
            9Cash
                paid for taxes
            
            
            314
            
            
            223





See
      Accompanying Notes to Condensed Consolidated Financial Statements








4





**Interactive
      Intelligence, Inc.**


**Notes
      to Condensed Consolidated Financial Statements**


**September
      30, 2006 and 2005 (unaudited)**





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





*The
      Company*





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


·
            Contact
                Centers,


·
            Enterprise
                IP Telephony,


·
            Unified
                Communications, and


·
            Self-service
                Automation.





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





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





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





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





These
      Condensed Consolidated Financial Statements should be read in conjunction with
      the Company’s audited Consolidated Financial Statements for the year ended
      December 31, 2005, included in the Company’s Form 10-K for the year ended
      December 31, 2005 as filed with the SEC. The Company’s results of operations for
      any interim period are not necessarily indicative of the results of operations
      for any other interim period or for a full fiscal year.





*Principles
      of Consolidation*





The
      Condensed Consolidated Financial Statements include the accounts of the Company
      and its wholly-owned subsidiaries after elimination of all significant
      intercompany accounts and transactions.








5





*Stock-Based
      Compensation Expense*





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





The
      Company adopted FAS 123R using the modified prospective transition method,
      which
      requires the application of the accounting standard as of January 1, 2006,
      the
      first day of the Company’s fiscal year. The Company’s Condensed Consolidated
      Financial Statements for all periods beginning on or after January 1, 2006
      reflect the impact of FAS 123R. In accordance with the modified prospective
      transition method, the Company’s Condensed Consolidated Financial Statements for
      prior periods have not been restated to reflect, and do not include, the impact
      of FAS 123R. Stock-based compensation expense for employee stock options
      recognized under FAS 123R for the three and nine months ended September 30,
      2006
      was $451,000 and $1.6 million, respectively.





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





Stock-based
      compensation expense recognized during the period is based on the value of
      the
      portion of share-based payment awards that is ultimately expected to vest.
      Stock-based compensation expense recognized in the Company’s Condensed
      Consolidated Statements of Income for the three and nine months ended September
      30, 2006 included compensation expense for share-based payment awards granted
      prior to, but not yet vested as of January 1, 2006, based on the grant date
      fair
      value estimated in accordance with the pro forma provisions of FAS 123, and
      compensation expense for the share-based payment awards granted subsequent
      to
      January 1, 2006 based on the grant date fair value estimated in accordance
      with
      the provisions of FAS 123R. Compensation expense for all share-based payment
      awards are recognized using the straight-line single option approach.
      Stock-based compensation expense recognized in the Company’s Condensed
      Consolidated Statements of Income for the three and nine months ended September
      30, 2006 is based on awards ultimately expected to vest and has been reduced
      for
      estimated forfeitures. FAS 123R requires forfeitures to be estimated at the
      time
      of grant and revised, if necessary, in subsequent periods if actual forfeitures
      differ from those estimates. Beginning with the Company’s implementation of FAS
      123R in January 2006, stock-based compensation expense has been reduced for
      estimated forfeitures. In the Company’s pro forma disclosure required under FAS
      123, for the periods prior to 2006, the Company accounted for forfeitures as
      they occurred.





With
      the
      adoption of FAS 123R, the Company continued to use the Black-Scholes
      option-pricing model as its method of valuation for share-based awards. For
      additional information, refer to Note 3. The Company’s determination of fair
      value of share-based payment awards on the date of grant using an option-pricing
      model is affected by the Company’s stock price as well as assumptions regarding
      a number of highly complex and subjective variables. These variables include,
      but are not limited to, the Company’s expected stock price volatility over the
      term of the awards and actual and projected employee stock option exercise
      behaviors. If factors change and the Company uses different assumptions for
      estimating stock-based compensation expense in future periods, stock-based
      compensation expense may differ materially in the future from that recorded
      in
      the current period.





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





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








6





The
      following table presents 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,****2006**
            
            **2005**
            
            **2006**
            
            **2005**Net
                income, as reported (A)
            
            $
            6,718
            
            $
            28
            
            $
            8,692
            
            $
            343Weighted
                average outstanding shares of common stock (B)
            
            
            16,626
            
            
            16,054
            
            
            16,438
            
            
            16,009Dilutive
                effect of options to purchase common stock
            
            
            1,919
            
            
            874
            
            
            1,572
            
            
            721Common
                stock and common stock equivalent shares (C)
            
            
            18,545
            
            
            16,928
            
            
            18,010
            
            
            16,730Net
                income per share:Basic
                (A/B)
            
            $
            0.40
            
            $
            0.00
            
            $
            0.53
            
            $
            0.02Diluted
                (A/C)
            
            
            0.36
            
            
            0.00
            
            
            0.48
            
            
            0.02





The
      Company’s calculation of diluted net income per share for the three months ended
      September 30, 2006 and 2005 excludes options to purchase 362,000 **** and
      1.8
      million shares of common stock, respectively, and diluted net income per share
      for the nine months ended September 30, 2006 and 2005 excludes options to
      purchase 379,000 **** and
      2.0
      million shares of common stock, respectively, as their effect would be
      antidilutive.





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





The
      Company's Stock Option Plans, adopted in 1995, 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 (2006 Plan), stock appreciation rights, restricted stock,
      restricted stock units, performance shares, performance units and other
      stock-based awards. The 2006 Plan was adopted at the Company’s 2006 Annual
      Meeting of Shareholders held in May 2006. After adoption of the 2006 Plan,
      the
      Company may no longer issue grants from previous plans, but any shares subject
      to awards under the 1999 Stock Option and Incentive Plan and the Outside
      Directors Stock Option Plan (the 1999 Plans) that are cancelled will be added
      to
      shares available under the 2006 Plan. A maximum of 4,950,933 shares are
      available for delivery under the 2006 Plan, which consists of (i) 1,250,000
      shares, plus (ii) 320,000 shares available for issuance under the 1999 Plans,
      but not underlying any outstanding stock options or other awards under the
      1999
      Plans, plus (iii) up to 3,380,933 shares subject to outstanding stock options
      or
      other awards under the 1999 Plans that expire, are forfeited or otherwise
      terminate unexercised on or after 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 incentive options must not be less than the fair market value
      of the common stock at the date of grant. Options granted under the 2006 Plan
      generally vest in equal annual installments over four years from the first
      anniversary of the date of grant, although vesting is at the Compensation
      Committee’s discretion.





For
      most
      options granted through December 31, 2004, the term of each option is ten years
      from the date of grant. In 2005, the Company began issuing options with a term
      of six years from the date of grant.





If
      an
      incentive option is granted to an employee who, at the time the option is
      granted, owns stock representing more than ten percent of the voting power
      of
      all classes of stock of the Company, the exercise price of the option may not
      be
      less than 110% of the market value per share on the date the option is granted
      and the term of the option shall be five years from the date of grant.





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





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





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








7




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





**Three
                Months**
              **Ended**
              **September
                30, 2005**
            
            **Nine
                Months**
              **Ended**
              **September
                30, 2005**Net
                income, as reported
            
            $
            28
            
            $
            343Add:
                Stock-based compensation expense included in reported net income,
                net of
                tax effects
            
            
            9
            
            
            70Deduct:
                Total stock-based compensation expense determined under fair value
                based
                method for all awards, net of
              related
                tax effects
            
            
            (726
            )
            
            (2,315
            )Pro
                forma net loss
            
            $
            (689
            )
            $
            (1,902
            )Net
                income (loss) per share:Basic-
                as reported
            
            $
            0.00
            
            $
            0.02Diluted-
                as reported
            
            
            0.00
            
            
            0.02Basic-
                pro forma
            
            
            (0.04
            )
            
            (0.12
            )Diluted-
                pro forma
            
            
            (0.04
            )
            
            (0.12
            )





*Valuation
      and Expense Information under FAS 123R*





The
      following table summarizes the allocation of stock-based compensation expense
      related to employee stock options under FAS 123R for the three and nine months
      ended September 30, 2006 (in thousands, except per share amounts):





**Three
                Months Ended**
              **September
                30, 2006**
            
            **Nine
                Months Ended**
              **September
                30, 2006**Stock-based
                compensation expense for employee stock options:Cost
                of services
            
            $
            38
            
            $
            116Sales
                and marketing
            
            
            219
            
            
            768Research
                and development
            
            
            69
            
            
            179General
                and administrative
            
            
            125
            
            
            545Total
                stock-based compensation expense for employee stock
                options
            
            $
            451
            
            $
            1,608Effect
                of stock-based compensation for employee stock options on net income
                per
                shareBasic
            
            $
            (0.03
            )
            $
            (0.10
            )Diluted
            
            
            (0.02
            )
            
            (0.09
            )





During
      the three and nine months ended September 30, 2006, the Company granted stock
      options for 16,750 and 613,929 shares of common stock, respectively, with an
      estimated total grant-date fair value of approximately $130,000 and $2.5
      million, respectively. As required by FAS 123R, management has made an estimate
      of expected forfeitures and is recognizing compensation costs only for those
      stock awards expected to vest. The Company estimated that the total stock-based
      compensation for the awards not expected to vest was $27,000 and $522,000,
      with
      such amounts deducted to arrive at the fair value of $130,000 and $2.5 million
      for the three and nine months ended September 30, 2006,
      respectively.





*Valuation
      Assumptions*





The
      Company estimated the fair value of stock options using the Black-Scholes
      valuation model. The fair value of each option grant is estimated on the date
      of
      grant and is amortized on a straight-line basis over the vesting period. The
      weighted-average estimated value of options granted to employees and directors
      under the stock option plans was $7.76 and $3.16 during the three months ended
      September 30, 2006 and 2005, respectively, and $4.08 and $3.11 during the nine
      months ended September 30, 2006 and 2005, respectively, using the Black-Scholes
      model with the following assumptions:





**As
                of September 30,****2006**
            
            **2005**Dividend
                yield
            
            
            --
            %
            
            --
            %Expected
                volatility
            
            
            66.57
            %
            
            73.75
            %Risk-free
                interest rate
            
            
            4.68
            %
            
            4.13
            %Expected
                life of option (in years)
            
            
            4.25
            
            
            7.50




8




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





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





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





*Expected
      Term* :
      The
      Company’s expected term represents the period that the Company’s stock options
      are expected to be outstanding and was determined using the simplified method
      described in SAB 107.





*Estimated
      Pre-vesting Forfeitures:* Beginning
      January 1, 2006, the Company included an estimate for forfeitures in calculating
      stock option expense. When estimating forfeitures, the Company considers
      historical termination behavior as well as any future trends it expects. Prior
      to 2006, the Company accounted for forfeitures of employee stock options for
      pro
      forma disclosure purposes under FAS 123 on an as-incurred basis.





*Stock
      Option Activity*





The
      following is a summary of option activities for the three and nine months ended
      September 30, 2006:





**Three
                Months Ended**
              **September
                30, 2006**
            
            **Nine
                Months Ended**
              **September
                30, 2006****Options**
            
            **Weighted**
              **Average**
              **Exercise**
              **Price**
            
            **Options**
            
            **Weighted
                Average Exercise Price**Beginning
                outstanding
            
            
            3,985,712
            
            $
            5.81
            
            
            3,853,688
            
            $
            5.44Options
                granted
            
            
            16,750
            
            
            11.56
            
            
            613,929
            
            
            7.15Options
                exercised
            
            
            (102,589
            )
            
            5.61
            
            
            (509,712
            )
            
            4.41Options
                canceled
            
            
            (10,875
            )
            
            6.30
            
            
            (68,907
            )
            
            5.59Ending
                outstanding
            
            
            3,888,998
            
            
            5.84
            
            
            3,888,998
            
            
            5.84Option
                price range at end of period
            
            
            $0.13
                - $50.50
            
            
            
            
            
            $0.13
                - $50.50Weighted
                average fair value of options granted during the period
            
            $
            7.76
            
            
            
            
            $
            4.08Options
                exercisable at end of period
            
            
            2,403,771Options
                available for grant at end of period
            
            
            1,349,571





The
      following table summarizes information about the options outstanding at
      September 30, 2006:





**Options
                Outstanding**
            
            **Options
                Exercisable****Range
                of Exercise Prices**
            
            **Number**
              **Outstanding**
            
            **Weighted**
              **Average**
              **Remaining**
              **Contractual**
              **Life**
            
            **Weighted**
              **Average**
              **Exercise**
              **Price**
            
            **Number**
              **Exercisable**
            
            **Weighted**
              **Average**
              **Exercise**
              **Price**$
                0.13 - $ 2.99
            
            
            414,560
            
            
            2.93
                years
            
            $
            1.66
            
            
            377,629
            
            $
            1.55$
                3.00 - $ 4.49
            
            
            953,272
            
            
            5.40
                years
            
            
            3.63
            
            
            555,102
            
            
            3.40$
                4.50 - $ 5.99
            
            
            1,787,633
            
            
            6.18
                years
            
            
            5.55
            
            
            1,030,624
            
            
            5.71$
                6.00 - $ 8.99
            
            
            182,108
            
            
            5.54
                years
            
            
            7.14
            
            
            116,241
            
            
            7.58$
                9.00 - $13.49
            
            
            423,286
            
            
            4.74
                years
            
            
            10.10
            
            
            196,036
            
            
            10.46$13.50
                - $50.50
            
            
            128,139
            
            
            4.11
                years
            
            
            23.91
            
            
            128,139
            
            
            23.91Total/average
            
            
            3,888,998
            
            
            5.39
                years
            
            $
            5.84
            
            
            2,403,771
            
            $
            5.97





The
      total
      intrinsic value of options exercised during the three and nine months ended
      September 30, 2006 was $881,000 and $2.9 million, respectively. The aggregate
      intrinsic value of options outstanding as of September 30, 2006 was $23.9
      million and the aggregate intrinsic value of options currently exercisable
      as of
      September 30, 2006 was $15.1 million. The aggregate intrinsic value represents
      the total intrinsic value, based on the Company’s closing stock price of $11.56
      as of September 30, 2006, which would have been realized by the option holders
      had all option holders exercised their options as of that date. The total number
      of in-the-money options exercisable as of September 30, 2006 was 2,233,132,
      with
      a weighted average exercise price of $4.82.


9





As
      of
      September 30, 2006, there was $4.5 million of total unrecognized compensation
      cost related to non-vested stock options. These costs are expected to be
      recognized over the weighted average remaining life of three years. The
      Company’s stock options generally vest over four years.





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





**4.**
            **Concentration
                of Credit Risk**





One
      reseller represented a 14% concentration of the Company’s accounts receivable as
      of September 30, 2006. No resellers or customers had greater than 10%
      concentration of accounts receivable as of December 31, 2005. In addition,
      no
      resellers or customers had greater than 10% concentration of the Company’s
      revenues for the three and nine months ended September 30, 2006 and
      2005.





**5.**
            **Contingencies**





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





On
      January 14, 2005, the Company entered into a non-exclusive license agreement
      with a telecommunication technology provider to use certain of its fax-related
      patents. As of September 30, 2006, the Company determined that it will owe
      the
      final payment under the agreement of $225,000. The Company has recorded an
      accrual for this amount as of September 30, 2006 and will pay the amount in
      the
      fourth quarter of 2006.





In
      November 2002, the Company received a notification from the French government
      as
      a result of a tax audit that had been conducted encompassing the years 1998,
      1999, 2000 and 2001. These assessments claim various taxes are owed related
      to
      Value Added Tax (VAT) and corporation taxes in addition to what has previously
      been paid and accrued. As of September 30, 2006, the assessment related to
      VAT
      was approximately $2.9 million. The Company’s tax counsel has assessed the
      possibility of the Company paying the assessment related to VAT as remote and
      therefore, the Company has not accrued the VAT amount. The Company has filed
      for
      VAT refunds in France of more than $600,000, for which the Company has not
      recorded as a receivable, and to which the French government has not yet
      responded. The Company believes that these VAT refunds could be used to offset
      amounts owed to the French government in connection with the assessments. As
      of
      September 30, 2006, the assessment related to corporation taxes was
      approximately $381,000. The Company’s tax counsel has assessed the possibility
      of the Company paying the assessment related to corporation taxes as reasonably
      possible. As of September 30, 2006, the Company has recorded what it deems
      an
      appropriate amount for corporation taxes. The Company is appealing both the
      VAT
      and corporation tax assessments, but cannot assure you that these matters will
      be resolved without litigation or that it will not have to pay some or all
      of
      the assessments.





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.





**6.**
            **Income
                Taxes**





The
      Company records income taxes in accordance with Statement of Financial
      Accounting Standards No. 109, *Accounting
      for Income Taxes* .
      Management considers, when assessing the realizability of deferred tax assets,
      whether it is more likely than not that some portion or all of the deferred
      tax
      assets will not be realized. The ultimate realization of deferred tax assets
      is
      dependent upon the generation of future taxable income during the periods in
      which those temporary differences become deductible. Management considers the
      scheduled reversal of deferred tax liabilities, if any, projected future taxable
      income, and tax planning strategies in making this assessment.








10





Based
      on
      a history of taxable losses or minimal taxable income, the Company determined
      that it was more likely than not that the benefit of the deferred tax assets
      would not be realized as of December 31, 2005, and therefore recorded a full
      valuation allowance of $23.1 million at the end of the period. As of December
      31, 2005, the Company had tax net loss carry-forwards of $42.5 million and
      tax
      credit carry-forwards of $3.8 million which expire from 2018 to 2025. Based
      upon
      improving performance of the business over the previous two years and the level
      of projections for future taxable income over the periods in which the deferred
      tax assets are deductible, management now believes it is more likely than not
      that the Company will be able to realize a portion of the benefits of the
      deferred tax assets and reversed a portion of the valuation allowance as of
      September 30, 2006. The Company recorded an income tax benefit of $5.0 million
      during the three months ended September 30, 2006 to reduce the valuation
      allowance for the deferred tax assets.





The
      Company will continue to evaluate the recoverability of the deferred tax assets
      on a quarterly basis. Unless circumstances indicate a change in the amount
      of
      deferred tax assets considered more likely than not to be recoverable, the
      Company will report income tax expense, as in previous quarters, with income
      tax
      expense principally related to foreign taxes.





**7.**
            **Recent
                Accounting Pronouncements**




In
      September 2006, the Financial Accounting Standards Board (FASB) issued Statement
      of Financial Accounting Standards No. 157, ** *Fair
      Value Measurements* (FAS
      157). FAS 157 defines fair value, establishes a framework for measuring fair
      value in generally accepted accounting principles and expands disclosures about
      fair value measurements. This Statement applies to previous accounting
      pronouncements that require or permit fair value measurements. Accordingly,
      this
      Statement does not require any new fair value measurements. FAS 157 is effective
      for fiscal years beginning after November 15, 2007. The Company is currently
      evaluating the impact, if any, the adoption of FAS 157 will have on its
      operating income or net earnings. The Company does not expect the adoption
      of
      FAS 157 will have a material impact on its consolidated financial position,
      results of operations or cash flows.





In
      September 2006, the SEC issued Staff Accounting Bulletin
      No. 108, ** *Considering
      the Effects of Prior Year Misstatements when Quantifying Misstatements in
      Current Year Financial Statements* (SAB
      108), which provides interpretive guidance on the consideration of the effects
      of prior year misstatements in quantifying current year misstatements for the
      purpose of a materiality assessment. SAB 108 is effective for fiscal years
      ending after November 15, 2006. Early application is encouraged, but not
      required. The Company is currently assessing the impact, if any, that the
      adoption of SAB 108 will have on its operating income or net earnings. The
      cumulative effect, if any, of applying the provisions of SAB 108 will be
      reported as an adjustment to beginning-of-year retained earnings in the year
      of
      adoption (January 1, 2006).





In
      July
      2006, the FASB released Interpretation No. 48, *Accounting
      for Uncertainty in Income Taxes, an Interpretation of FASB Statement No. 109* (FIN
      48).
      FIN 48 clarifies the accounting and reporting for uncertainty in income taxes
      recognized in an enterprise’s financial statements. This interpretation
      prescribes a comprehensive model for the financial statement recognition,
      measurement, presentation and disclosure of uncertain tax positions taken or
      expected to be taken on income tax returns. FIN 48 is effective for fiscal
      years
      beginning after December 15, 2006. Early application is encouraged, but not
      required. The Company is currently assessing the impact, if any, that the
      adoption of FIN 48 will have on its operating income or net earnings, however
      the Company does not expect the adoption of FIN 48 will have a material impact
      on its consolidated financial position, results of operations or cash
      flows.





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





**Forward-Looking
      Information**





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








11





**Overview**





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





**Financial
      Highlights**




For
      the
      three months ended September 30, 2006, revenues grew 15% over the immediately
      preceding three month period and 46% over the three months ended September
      30,
      2005. Factors that affect revenues in any particular quarter include the
      adoption of new technologies, expansion of current usage of systems, customers’
budget constraints, personnel resources to implement our solutions, and
      willingness to implement a critical telecommunications system. As shown in
      the
      table below, revenues in any particular quarter can fluctuate from other
      periods. Because of particular contract terms or our payment experience with
      certain customers or resellers, revenue recognition may occur in periods later
      than when an order is received.





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





**Period**
            
            **Revenues**
            
            **Sequential**
              **%
                Growth**
            
            **Year
                Over Year**
              **%
                Growth**Three
                months ended:September
                30, 2006
            
            $
            22.2
            
            
            15
            %
            
            46
            %June
                30, 2006
            
            
            19.3
            
            
            7
            
            
            23March
                31, 2006
            
            
            17.9
            
            
            2
            
            
            23December
                31, 2005
            
            
            17.5
            
            
            15
            
            
            22September
                30, 2005
            
            
            15.2
            
            
            (3
            )
            
            13Year
                ended December 31:2005
            
            $
            62.9
            
            
            14
            %2004
            
            
            55.1
            
            
            72003
            
            
            51.5
            
            
            8





We
      have
      experienced increasing revenue growth, which we attribute to a number of factors
      including but not limited to: adoption of voice over Internet protocol
      technologies by our customers; product improvements in scalability and the
      reliability of our products; reductions in hardware costs to deploy our
      solutions making our solutions more financially attractive to customers; changes
      in our sales program to target new customers; and establishment of an inside
      sales group to work with current customers.





For
      the
      three and nine months ended September 30, 2006, product revenues increased
      56%
      and 26%, compared to the three and nine months ended September 30, 2005,
      respectively. The large increase in product revenues was related to an increase
      in the dollar value of orders received during the three and nine months ended
      September 30, 2006 compared to the three and nine months ended September 30,
      2005, respectively. Finally, the average order size increased as we continued
      to
      target larger companies to license our products.





For
      the
      three and nine months ended September 30, 2006, services revenues increased
      35%
      and 36% compared to the three and nine months ended September 30, 2005,
      respectively. The increase in services revenues was principally related to
      an
      increase in support fees and annually renewable license fees, which were
      recognized for our growing installed customer base, and which were approximately
      82% of services revenues for both the three and nine months ended September
      30,
      2006. In addition, other services revenues, such as professional services and
      education, increased a total of 27% and 32% in the three and nine months ended
      September 30, 2006 compared to the three and nine months ended September 30,
      2005, respectively.





Cost
      of
      revenues increased $3.0 million and $5.5 million for the three and nine months
      ended September 30, 2006 compared to the three and nine months ended September
      30, 2005, respectively. The increases for both periods were the result of
      increased hardware costs for handsets, servers, and gateways related to our
      IP
      PBX product, increased personnel-related costs in the services department and
      increased royalty expenses, including royalty expense. During the three months
      ended September 30, 2006, we recorded a one-time charge of $122,000 related
      to a
      non-exclusive license agreement with a telecommunication technology provider.
      This related to the final contractual payment under the license agreement of
      $225,000, which we will remit during the fourth quarter of 2006. The remaining
      $103,000 will be amortized over the remaining life of the fax-related patents
      of
      six years.








12





Effective
      January 1, 2006, we adopted the Statement of Financial Accounting Standards
      No.
      123 (revised 2004), *Share-Based
      Payment* (FAS
      123R) which requires the measurement and recognition of compensation expense
      for
      all share-based payment awards made to employees under our stock option plans,
      based on fair values. The adoption of FAS 123R had a significant effect on
      our
      costs during the three and nine month periods ended September 30, 2006 compared
      to the comparable periods a year ago before the expense was recorded. The
      following table summarizes stock-based compensation expense related to employee
      stock options under FAS 123R for the three and nine months ended September
      30,
      2006 which was allocated as follows (in thousands, except per share
      amounts):





**Three
                Months**
              **Ended**
              **September
                30, 2006**
            
            **Nine
                Months**
              **Ended**
              **September
                30, 2006**Stock-based
                compensation expense for employee stock options:Cost
                of services
            
            $
            38
            
            $
            116Sales
                and marketing
            
            
            219
            
            
            768Research
                and development
            
            
            69
            
            
            179General
                and administrative
            
            
            125
            
            
            545Total
                stock-based compensation expense for employee stock
                options
            
            $
            451
            
            $
            1,608Diluted
                net income per share - as reported
            
            $
            0.36
            
            $
            0.48Effect
                of stock-based compensation for employee stock options on net income
                per
                share:Basic
            
            $
            (0.03
            )
            $
            (0.10
            )Diluted
            
            
            (0.02
            )
            
            (0.09
            )





Operating
      expenses increased $2.4 million and $5.3 million for the three and nine months
      ended September 30, 2006 compared to the three and nine months ended September
      30, 2005, respectively. These increases were partially due to stock-based
      compensation expense related to FAS 123R, as detailed above. In addition, we
      experienced increases in compensation expenses as a result of increased
      staffing, commission expenses and increased marketing expenses. These increases
      were slightly offset by decreases in depreciation, particularly in research
      and
      development.





We
      had
      $22.3 million of cash and cash equivalents and short-term investments as of
      September 30, 2006. Cash and cash equivalents and short-term investments
      increased from $15.1 million as of December 31, 2005 principally as a result
      of
      net earnings (excluding the non-cash tax benefit of $5.0 million) for the nine
      months ended September 30, 2006, increased deferred services revenues and
      exercises of stock options. These increases were offset in part by cash used
      as
      a result of increases in accounts receivable and prepaid expenses, and purchases
      of property and equipment.





Based
      on
      currently issued non-vested options, we expect 2006 stock-based compensation
      expenses related to FAS 123R to be just over $2.0 million, with approximately
      $425,000 for the three months ended December 31, 2006.





Due
      to
      our public float exceeding $75 million as of June 30, 2006, we will be deemed
      an
“accelerated filer” by the SEC as of December 31, 2006 for purposes of Section
      404 of the Sarbanes-Oxley Act of 2002. We are currently in the process of
      documenting, evaluating and testing our internal control over financial
      reporting and believe that we will be able to complete all requirements by
      the
      deadline for the filing of our Form 10-K for the year ending December 31, 2006.
      We have incurred costs for the nine months ended September 30, 2006 of over
      $230,000 related to consulting fees and anticipate additional costs as we
      continue to address these requirements.





We
      recorded an income tax benefit of $5.0 million during the three months ended
      September 30, 2006 to reduce the valuation allowance for our deferred tax
      assets. We will continue to evaluate the recoverability of the deferred tax
      assets on a quarterly basis. Unless circumstances indicate a change in the
      amount of deferred tax assets considered more likely than not to be recoverable,
      we will report income tax expense, as in previous quarters, with income tax
      expense principally related to foreign taxes.








13


**Historical
      Results of Operations**




The
      following table presents certain financial data, derived from our unaudited
      Condensed Consolidated 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, 2006 and 2005 are not necessarily indicative of the results
      that may be expected for the full year or for any future period.





**Three
                Months Ended**
              **September
                30,**
            
            **Nine
                Months Ended**
              **September
                30,****2006**
            
            **2005**
            
            **2006**
            
            **2005**Revenues:Product
            
            
            55
            %
            
            51
            %
            
            52
            %
            
            53
            %Services
            
            
            45
            
            
            49
            
            
            48
            
            
            47Total
                revenues
            
            
            100
            
            
            100
            
            
            100
            
            
            100Cost
                of revenues:Product
            
            
            12
            
            
            6
            
            
            10
            
            
            6Services
            
            
            18
            
            
            18
            
            
            18
            
            
            18Total
                cost of revenues
            
            
            30
            
            
            24
            
            
            28
            
            
            24Gross
                profit
            
            
            70
            
            
            76
            
            
            72
            
            
            76Operating
                expenses:Sales
                and marketing
            
            
            35
            
            
            41
            
            
            36
            
            
            40Research
                and development
            
            
            15
            
            
            20
            
            
            16
            
            
            21General
                and administrative
            
            
            12
            
            
            14
            
            
            14
            
            
            14Total
                operating expenses
            
            
            62
            
            
            75
            
            
            66
            
            
            75Operating
                income
            
            
            8
            
            
            1
            
            
            6
            
            
            1Other
                income (expense):Interest
                income, net
            
            
            1
            
            
            --
            
            
            1
            
            
            --Other
                expense, net
            
            
            --
            
            
            (1
            )
            
            --
            
            
            --Total
                other income (expense)
            
            
            1
            
            
            (1
            )
            
            1
            
            
            --Income
                before income taxes
            
            
            8
            
            
            --
            
            
            7
            
            
            1Income
                tax benefit (expense)
            
            
            22
            
            
            --
            
            
            8
            
            
            --Net
                income
            
            
            30
            %
            
            --
            %
            
            15
            %
            
            1
            %


**Comparison
      of Three and Nine Months Ended September 30, 2006 and 2005**




***Revenues***




*Product
      Revenues*




**Three
                Months Ended**
              **September
                30,**
            
            **Nine
                Months Ended**
              **September
                30,****2006**
            
            **2005**
            
            **2006**
            
            **2005****($
                in thousands)**Product
                revenues
            
            $
            12,143
            
            $
            7,783
            
            $
            30,590
            
            $
            24,265Change
                from prior year
            
            
            56
            %
            
            18
            %
            
            26
            %
            
            16
            %Percentage
                of total revenues
            
            
            55
            %
            
            51
            %
            
            52
            %
            
            53
            %





The
      increase in product revenues during the three months ended September 30, 2006
      compared to the three months ended September 30, 2005 was due to an increase
      in
      the total orders. The total dollar amount of orders increased 62% for the three
      months ended September 30, 2006 compared to the three months ended September
      30,
      2005 with relatively faster growth in the North American and EMEA regions.
      Contributing to the total dollar amount of orders increase was a 42% increase
      in
      the IP PBX products sold under our Vonexus brand. In addition, for the three
      months ended September 30, 2006 compared to the three months ended September
      30,
      2005 the total dollar amount of new contracts increased 126% and the average
      contract amount for new customer orders increased from $58,000 to $99,000 per
      contract.





The
      increase in product revenues for the nine months ended September 30, 2006
      compared to the nine months ended September 30, 2005 was also a result of an
      increase in the dollar amount of orders, specifically from the EMEA region.
      The
      total dollar amount of orders increased 39% for the nine months ended September
      30, 2006 compared to the nine months ended September 30, 2005. Contributing
      to
      the total dollar amount of orders increase was a 103% increase in the IP PBX
      products sold under our Vonexus brand. In addition, for the nine months ended
      September 30, 2006 compared to the nine months ended September 30, 2005 the
      total dollar amount of new contracts increased 59% and the average contract
      amount for new customer orders increased from $72,000 to $94,000 per
      contract.


14





The
      product revenues as a percentage of total revenues increased for the three
      months ended September 30, 2006 due to a higher percentage increase in product
      revenues, including hardware we resell, compared to the increase in services
      revenues.





Product
      revenues can fluctuate from quarter to quarter depending on the mix of contracts
      sold between perpetual licenses and annually renewable licenses. The
      product revenue effect of perpetual licenses is that we recognize license
      revenue upfront, whereas for annually renewable licenses, we recognize the
      license revenue ratably over the term. The impact of the mix of contracts on
      our
      product revenues occurs only in the initial year of the contracts as the renewal
      fees received for the annually renewable licenses and the renewal support fees
      for perpetual contracts are all allocated entirely to services revenues.
      Perpetual contracts for the three and nine months ended September 30, 2006
      accounted for 78% and 75%, respectively, of product revenues compared to 70%
      and
      71% for the same periods in 2005.





If
      we
      continue to sell more hardware products with our software applications, product
      costs should increase. Because the margin is lower on hardware sales, this
      could
      have a negative impact on our gross margin percentage.








*Services
      Revenues*




**Three
                Months Ended**
              **September
                30,**
            
            **Nine
                Months Ended**
              **September
                30,****2006**
            
            **2005**
            
            **2006**
            
            **2005****($
                in thousands)**Services
                revenues:Support
                and license renewals
            
            $
            8,261
            
            $
            6,012
            
            $
            23,667
            
            $
            17,276Other
            
            
            1,769
            
            
            1,393
            
            
            5,099
            
            
            3,862Total
                services revenues
            
            $
            10,030
            
            $
            7,405
            
            $
            28,766
            
            $
            21,138Change
                from prior year
            
            
            35
            %
            
            9
            %
            
            36
            %
            
            7
            %Percentage
                of total revenues
            
            
            45
            %
            
            49
            %
            
            48
            %
            
            47
            %





Services
      revenues include the portion of the initial license arrangement allocated to
      services revenues from annually renewable and perpetual contracts, license
      renewals of annually renewable contracts, and support fees for perpetual
      contracts, as well as professional services, education and other miscellaneous
      revenues.





Revenues
      from license renewals and support fees increased 37% for both the three and
      nine
      months ended September 30, 2006 compared to the three and nine months ended
      September 30, 2005 primarily due to increasing amounts of license renewals
      and
      support fees from our growing customer base. Other services revenues for the
      three and nine months ended September 30, 2006 increased primarily due to an
      increase in professional services engagements and training classes delivered
      compared to the same periods in 2005.





Our
      support and license renewal revenues should continue to increase as we implement
      new customers and as existing customers continue to renew annually renewable
      licenses or perpetual support agreements for our applications. The actual
      percentage fee charged for renewal of annually renewable licenses and perpetual
      support agreements as compared to the initial annually renewable license fee
      and
      perpetual license, respectively, is comparable on a relative percentage basis,
      and therefore, the mix of these types of contracts in the future will not impact
      our future services revenues.




***Cost
      of Revenues***




**Three
                Months Ended**
              **September
                30,**
            
            **Nine
                Months Ended**
              **September
                30,****2006**
            
            **2005**
            
            **2006**
            
            **2005****($
                in thousands)**Cost
                of revenues:Product
            
            $
            2,707
            
            $
            963
            
            $
            6,073
            
            $
            2,837Services
            
            
            3,950
            
            
            2,743
            
            
            10,409
            
            
            8,153Total
                cost of revenues
            
            $
            6,657
            
            $
            3,706
            
            $
            16,482
            
            $
            10,990Change
                from prior year
            
            
            80
            %
            
            23
            %
            
            50
            %
            
            15
            %Product
                costs as a % of product revenues
            
            
            22
            %
            
            12
            %
            
            20
            %
            
            12
            %Services
                costs as a % of services revenues
            
            
            39
            %
            
            37
            %
            
            36
            %
            
            39
            %








15





Costs
      of
      product consist primarily of hardware that we resell, product and software
      royalties paid to third parties for the use of their technologies in our
      products and, to a lesser extent, software packaging costs, which include
      product media, duplication and documentation. Costs of product can fluctuate
      depending on third party technology, if any, which is licensed by the end user
      from us as part of our software applications and the dollar amount of IP PBX
      systems licensed which include hardware such as servers, telephone handsets,
      networking equipment and other hardware. The increase in the product costs
      for
      the three and nine months ended September 30, 2006 compared to the three and
      nine months ended September 30, 2005 was due to IP PBX hardware costs which
      we
      expect will continue to increase if we license increasing amounts of IP PBX
      systems. In addition, in the three and nine months ended September 30, 2006
      we
      experienced an increase in royalties paid to third party software providers
      over
      the same periods of 2005 as a result of increased licensing of third party
      products by our end users from us as part of our software applications.





During
      the three months ended September 30, 2006, we recorded a one-time charge of
      $122,000 related to a non-exclusive license agreement with a telecommunication
      technology provider. This related to the final contractual payment under the
      license agreement of $225,000, which we will remit during the fourth quarter
      of
      2006. The remaining $103,000 will be amortized over the remaining life of the
      fax-related patents of six years. Software royalties will vary depending on
      third party software licenses recognized in each quarter.





Product
      costs as a percentage of product revenues increased during the three and nine
      months ended September 30, 2006 compared to the three and nine months ended
      September 30, 2005, principally due to an increase in our hardware costs related
      to our IP PBX product.





Costs
      of
      services consist primarily of compensation expenses for technical support,
      professional services and education personnel and other costs associated with
      supporting our resellers and customers. Salary costs, excluding commissions
      and
      other incentives, represented 52% and 53% of total services expenses for the
      three and nine months ended September 30, 2006. These costs increased for the
      three and nine months ended September 30, 2006 compared to the three and nine
      months ended September 30, 2005 primarily due to an increase in salary-related
      expenses as headcount increased from 93 to 133 total support and services
      employees from September 30, 2005 to September 30, 2006. Costs of services
      also
      increased due to an increase in travel-related expenses of $179,000 and $370,000
      and an increase in outsourced services of $170,000 and $289,000 for the three
      and nine months ended September 30, 2006 compared to the three and nine months
      ended September 30, 2005, respectively. Both the travel-related expenses and
      the
      outsourced services were mainly related to increases in our professional
      services opportunities. Stock-based compensation expense related to FAS 123R
      for
      cost of services personnel was $38,000 and $116,000 for the three and nine
      months ended September 30, 2006, respectively.







***Gross
      Profit***




**Three
                Months Ended**
              **September
                30,**
            
            **Nine
                Months Ended**
              **September
                30,****2006**
            
            **2005**
            
            **2006**
            
            **2005****($
                in thousands)**Gross
                profit
            
            $
            15,516
            
            $
            11,482
            
            $
            42,874
            
            $
            34,413Change
                from prior year
            
            
            35
            %
            
            10
            %
            
            25
            %
            
            10
            %Percentage
                of total revenues
            
            
            70
            %
            
            76
            %
            
            72
            %
            
            76
            %





As
      we
      continue to sell hardware with our software applications, our gross profit
      margin may decrease compared to historical margins. Gross margin in any
      particular quarter is dependent on our product mix and is expected to
      vary.




***Operating
      Expenses***




*Sales
      and Marketing*




**Three
                Months Ended**
              **September
                30,**
            
            **Nine
                Months Ended**
              **September
                30,****2006**
            
            **2005**
            
            **2006**
            
            **2005****($
                in thousands)**Sales
                and marketing expenses
            
            $
            7,694
            
            $
            6,188
            
            $
            21,428
            
            $
            18,188Change
                from prior year
            
            
            24
            %
            
            17
            %
            
            18
            %
            
            18
            %Percentage
                of total revenues
            
            
            35
            %
            
            41
            %
            
            36
            %
            
            40
            %Percentage
                of product revenues
            
            
            63
            %
            
            80
            %
            
            70
            %
            
            75
            %








16





Sales
      and
      marketing expenses are comprised primarily of compensation expenses, travel
      and
      entertainment expenses and promotional costs related to our sales, marketing,
      and channel management operations. These expenses increased due to several
      factors. Commission expense increased $335,000 for the three months ended
      September 30, 2006 compared to the three months ended September 30, 2005 and
      increased $1.2 million for the nine months ended September 30, 2006 compared
      to
      the nine months ended September 30, 2005. We increased our marketing efforts
      during 2006 which resulted in an increase in expenses related to marketing
      activities of $307,000 and $431,000 for the three and nine months ended
      September 30, 2006 compared to the three and nine months ended September 30,
      2005, respectively. In addition, stock-based compensation expense related to
      FAS
      123R for sales and marketing personnel was $219,000 and $768,000 for the three
      and nine months ended September 30, 2006, respectively. During the three months
      ended September 30, 2006, we incurred over $200,000 for referral fees to outside
      parties on two large orders. Finally during the three months ended September
      30,
      2006, we expanded our partner program to encourage further training on our
      products and incurred expenses of $176,000.





Sales
      and
      marketing expenses as a percentage of total revenues and as a percentage of
      product revenues decreased for both the three and nine months ended September
      30, 2006 compared to the three and nine months ended September 30, 2005. These
      decreases reflect efficiencies that we are realizing in these areas as our
      revenues continue to grow.





*Research
      and Development*




**Three
                Months Ended**
              **September
                30,**
            
            **Nine
                Months Ended**
              **September
                30,****2006**
            
            **2005**
            
            **2006**
            
            **2005****($
                in thousands)**Research
                and development expenses
            
            $
            3,414
            
            $
            3,061
            
            $
            9,676
            
            $
            9,468Change
                from prior year
            
            
            12
            %
            
            (5
            )%
            
            2
            %
            
            (3
            )%Percentage
                of total revenues
            
            
            15
            %
            
            20
            %
            
            16
            %
            
            21
            %





Research
      and development expenses are comprised primarily of compensation and
      depreciation expenses. Depreciation expense decreased by $70,000 for the three
      months ended September 30, 2006 compared to the three months ended September
      30,
      2005, and decreased by $318,000 for the nine months ended September 30, 2006
      compared to the nine months ended September 30, 2005, as certain of our assets
      became fully depreciated. This was offset by salary expense increases of
      $213,000 and $407,000 for the three and nine months ended September 30, 2006
      compared to the three and nine months ended September 30, 2005, respectively.
      These increases were the result of additional staff hired in 2006. In addition,
      stock-based compensation expense related to FAS 123R for research and
      development personnel was $69,000 and $179,000 for the three and nine months
      ended September 30, 2006, respectively.





*General
      and Administrative*




**Three
                Months Ended**
              **September
                30,**
            
            **Nine
                Months Ended**
              **September
                30,****2006**
            
            **2005**
            
            **2006**
            
            **2005****($
                in thousands)**General
                and administrative expenses
            
            $
            2,739
            
            $
            2,153
            
            $
            8,106
            
            $
            6,209Change
                from prior year
            
            
            27
            %
            
            16
            %
            
            31
            %
            
            10
            %Percentage
                of total revenues
            
            
            12
            %
            
            14
            %
            
            14
            %
            
            14
            %





General
      and administrative expenses are comprised of compensation expense and general
      corporate expenses that are not allocable to other departments including legal
      and other professional fees and bad debt. The increase for the three months
      ended September 30, 2006 compared to the three months ended September 30, 2005
      was primarily due to higher salary and related expenses of $426,000 due to
      an
      increase in staffing and higher management incentives due to the operating
      results. The increase for the nine months ended September 30, 2006 compared
      to
      the nine months ended September 30, 2005 was primarily due to an increase in
      professional services of $150,000 related to legal fees and costs for
      Sarbanes-Oxley 404 compliance, and higher salary and related expenses of
      $662,000 due to an increase in staffing. Finally, stock-based compensation
      expense related to FAS 123R for general and administrative personnel was
      $125,000 and $545,000 for the three and nine months ended September 30, 2006,
      respectively. The stock-based compensation expense in the nine months ended
      September 30, 2006 included almost $200,000 of expense recorded in the three
      months ended June 30, 2006 for option grants in May 2006 to outside Directors
      that were fully vested upon grant and therefore completely expensed at that
      time.





17







***Other
      Income (Expense)***




*Interest
      Income, Net*





**Three
                Months Ended**
              **September
                30,**
            
            **Nine
                Months Ended**
              **September
                30,****2006**
            
            **2005**
            
            **2006**
            
            **2005****($
                in thousands)**Cash,
                cash equivalents and short-term investments (average)
            
            $
            21,255
            
            $
            13,666
            
            $
            18,734
            
            $
            14,148Interest
                income
            
            
            201
            
            
            70
            
            
            430
            
            
            191Return
                on investment
            
            
            3.8
            %
            
            2.0
            %
            
            3.1
            %
            
            1.8
            %





Interest
      income, net is primarily comprised of interest earned from investments and
      interest-bearing cash accounts. Interest expense and fees, which are not
      material for any periods reported, are also included in interest income, net.
      Interest earnings improved during the three and nine months ended September
      30,
      2006 compared to the three and nine months ended September 30, 2005 as shown
      above. Interest earned on investments improved partially due to an increasing
      investment balance. In addition, we reallocated the funds in which we have
      invested to increase our return on investment. The new investments have higher
      interest rates and lower fees.





*Other
      Expense, Net*





**Three
                Months Ended**
              **September
                30,**
            
            **Nine
                Months Ended**
              **September
                30,****2006**
            
            **2005**
            
            **2006**
            
            **2005****($
                in thousands)**Other
                expense, net
            
            $
            (25
            )
            $
            (74
            )
            $
            (89
            )
            $
            (256
            )





Other
      expense, net includes foreign currency transaction gains and losses, as well
      as
      foreign tax withholdings. These amounts depend on the amount of revenue that
      is
      generated in certain international currencies, particularly the Euro, and the
      exchange gain or loss that results from foreign currency disbursements and
      receipts. The decrease during the three and nine months ended September 30,
      2006
      was principally due to a decrease in foreign tax withholdings and foreign
      currency conversion charges compared to the same periods in 2005.





*Income
      Tax Benefit (Expense)*





We
      had
      $42.5 million of tax net operating loss carry-forwards and $3.8 million in
      tax
      credit carry-forwards at the beginning of 2006, all of which were fully reserved
      for financial reporting purposes. During 2006, our estimated taxable income
      continued to increase and during the three months ended September 30, 2006,
      we
      determined that it was more likely than not, based on our projections of future
      earnings, that we would be able to utilize a portion of the deferred tax assets
      resulting from the tax loss and tax credit carry-forwards. We recorded an income
      tax benefit of $5.0 million during the three months ended September 30, 2006
      to
      reduce the valuation allowance for our deferred tax assets. We will continue
      to
      evaluate the recoverability of the deferred tax assets on a quarterly basis.
      Unless circumstances indicate a change in the amount of deferred tax assets
      considered more likely than not to be recoverable, we will report income tax
      expense, as in previous quarters, with the income tax expense principally
      related to foreign taxes.





**Liquidity
      and Capital Resources**




We
      generate cash primarily from licensing our applications, annual license
      renewals, support fees and other services revenues and from our employees
      exercising stock options. We also have in place a $3 million line of credit,
      which we did not utilize as of September 30, 2006. We use cash primarily for
      paying our employees (including salaries, commissions and benefits), leasing
      office space, paying travel expenses, marketing activities, paying vendors
      for
      hardware, services, supplies and royalties and purchasing property and
      equipment.








18





We
      determine liquidity by combining cash and cash equivalents and short-term
      investments as shown in the table below. Our total liquidity position as of
      September 30, 2006 improved compared with our position as of December 31, 2005
      due mainly to increased net income (excluding the non-cash tax benefit of $5.0
      million), increased deferred services revenues and increased stock option
      exercises, offset in part by an increase in accounts receivable, prepaid
      expenses and purchases of property and equipment. We believe that our current
      liquidity position, when combined with our anticipated cash flows from
      operations, will be sufficient to satisfy our operating cash needs over the
      next
      12 months. If cash flows from operations are less than anticipated or we have
      additional cash needs (such as an unfavorable outcome in legal proceedings),
      our
      liquidity may not be sufficient to cover our needs. In this case, we may be
      forced to raise additional capital, either through the capital markets or debt
      financings. On October 19, 2006, we filed a registration statement on Form
      S-3
      that, when declared effective by the SEC, will allow us to raise additional
      capital. We may not be able to receive favorable terms in raising this capital.





**September
                30,**
            
            **December
                31,****2006**
            
            **2005****($
                in thousands)**Cash
                and cash equivalents
            
            $
            13,007
            
            $
            11,551Short-term
                investments
            
            
            9,333
            
            
            3,576Liquidity,
                net
            
            $
            22,340
            
            $
            15,127





Our
      operating activities resulted in net cash provided of $6.6 million and $120,000
      for the nine months ended September 30, 2006 and 2005, respectively. This
      increase in net cash provided was primarily a result of increased net income
      and
      increased deferred services revenues offset in part by increases in accounts
      receivable and prepaid expenses.





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





We
      purchased property and equipment with a cost of $1.9 million and $1.5 million
      in
      the nine months ended September 30, 2006 and 2005, respectively. These purchases
      related mainly to hardware and leasehold improvements for our corporate
      headquarters and new regional headquarters offices. As our property and
      equipment becomes obsolete and as our operations continue to grow, we anticipate
      that our purchases of property and equipment will continue to increase in future
      periods.





Net
      cash
      provided by financing activities was $2.4 million and $491,000 for the nine
      months ended September 30, 2006 and 2005, respectively. The increase in cash
      provided was mainly due to proceeds from stock options that were exercised
      during the period. As our stock price fluctuated during the period from $5.10
      per share as of December 31, 2005 up to $16.69 per share during the nine months
      ended September 30, 2006, more stock options were exercised compared to the
      prior year period. Our stock price was $11.56 per share as of September 30,
      2006.





On
      October 19, 2006, we filed with the SEC a registration statement on Form S-3
      utilizing the “shelf” registration process. This registration statement has not
      yet been declared effective by the SEC but if and when effective, it will allow
      us to offer and sell up to 3,000,000 shares of our common stock from time to
      time in one or more transactions. In addition, under this shelf registration
      statement, Dr. Donald E. Brown, our Chairman of the Board, President and CEO,
      registered 1,000,000 shares of our common stock that he owns for sale from
      time
      to time. Although the shelf registration statement, if and when effective,
      will
      permit us to offer and sell up to 3,000,000 shares of our common stock, doing
      so
      remains at the discretion of the Board of Directors, and there is no assurance
      that we would be able to complete any such offering of our common stock.





There
      have been no material changes in our contractual obligations described in our
      Form 10-K for the year ended December 31, 2005, except for the additional
      amounts listed below. The obligations listed below all relate to operating
      lease
      obligations for additional offices in the Netherlands, United Kingdom and United
      States.





**Payments
                Due by Period****Total**
            
            **Less
                than**
              **1
                Year**
            
            **1-3
                Years**
            
            **4-5
                Years**
            
            **More
                than**
              **5
                Years****($
                in thousands)****Contractual
                Obligations**Operating
                lease obligations
            
            $
            2,222
            
            $
            153
            
            $
            1,383
            
            $
            533
            
            $
            153








19





**Critical
      Accounting Policies and Estimates**




We
      believe the accounting policies listed below are important to understanding
      our
      historical and future performance, as these policies affect the reported amounts
      of revenues and are the more significant areas involving management’s judgments
      and estimates. These policies, and our procedures related to these policies,
      are
      described below.





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





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





*Product
      Revenues*




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


·
            Persuasive
                evidence of an arrangement exists;


·
            The
                fee is fixed or determinable;


·
            Collectibility
                is reasonably assured; and


·
            Delivery
                has occurred.





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





For
      perpetual license agreements, we recognize revenues related to any hardware
      sales when the hardware is delivered and all other criteria are met.





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





*Services
      Revenues*




Services
      revenues are primarily recognized for renewal fees and support related to
      annually renewable license agreements and support fees for perpetual license
      agreements. For annually renewable agreements, the allocation of the initial
      order between product revenues and services revenues is based on the average
      renewal rates of all time based contracts.  We apply the allocation of
      product revenues and services revenues consistently to all annually renewable
      agreements. Under annually renewable license agreements, after the initial
      license period, our customers may renew their license agreement for an
      additional period, typically 12 months, by paying a renewal fee.  The
      revenue for the annual renewal fees are all classified under services revenue
      and the revenue is recognized ratably over the contract period.  Under
      perpetual license agreements, we recognize annual support fees as services
      revenues ratably over the post-contract support period, which is typically
      12
      months.





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








20





***Stock-Based
      Compensation Expense***





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





We
      adopted FAS 123R using the modified prospective transition method, which
      requires the application of the accounting standard as of January 1, 2006,
      the
      first day of our fiscal year. The Condensed Consolidated Financial Statements
      for all periods beginning January 1, 2006 reflect the impact of FAS 123R. In
      accordance with the modified prospective transition method, the Condensed
      Consolidated Financial Statements for prior periods have not been restated
      to
      reflect, and do not include, the impact of FAS 123R.





With
      the
      adoption of FAS 123R, we continued to use the Black-Scholes option-pricing
      model
      as our method of valuation for share-based payment awards. Our determination
      of
      fair value of share-based payment awards on the date of grant using an
      option-pricing model is affected by our stock price as well as assumptions
      regarding a number of highly complex and subjective variables. These variables
      include, but are not limited to, our expected stock price volatility over the
      term of the awards, an expected risk-free rate of return and actual and
      projected employee stock option exercise behaviors. If factors change and we
      use
      different assumptions for estimating stock-based compensation expense in future
      periods, stock-based compensation expense may differ materially in the future
      from that recorded in the current period.





For
      additional information, refer to Note 3 to the Condensed Consolidated Financial
      Statements. Stock-based compensation expense for employee stock options
      recognized under FAS 123R for the three and nine months ended September 30,
      2006
      was $451,000 and $1.6 million, respectively.





***Income
      Taxes***





Statement
      of Financial Accounting Standards (FAS) No. 109, *Accounting
      for Income Taxes* (FAS
      109), establishes financial accounting and reporting standards for the effect
      of
      income taxes. We are subject to income taxes in both the United States and
      numerous foreign jurisdictions. Significant judgment is required in evaluating
      our tax positions and determining our provision for income taxes. The objectives
      of accounting for income taxes are to recognize the amount of taxes payable
      or
      refundable for the current year and deferred tax liabilities and assets for
      the
      future tax consequences of events that have been recognized in an entity’s
      financial statements or tax returns. Variations in the actual outcome of these
      future tax consequences could materially impact our financial position, results
      of operations, or cash flows.





In
      assessing the recoverability of deferred tax assets, management considers
      whether it is more likely than not that some portion or all of the deferred
      tax
      assets will not be realized. The ultimate realization of deferred tax assets
      is
      dependent upon generation of future taxable income during the periods in which
      temporary differences become deductible. Management considers projected future
      taxable income and tax planning strategies in making this assessment and
      ensuring that the deferred tax asset valuation allowance is adjusted as
      appropriate.





At
      the
      beginning of 2006, we had $42.5 million of tax net operating loss carry-forwards
      and $3.8 million in tax credit carry-forwards, all of which were fully reserved
      for financial reporting purposes. During the three months ended September 30,
      2006, we recorded a tax benefit of $5.0 million to reduce the valuation
      allowance for the deferred tax assets. We will continue to evaluate the
      valuation allowance in accordance with the requirements of FAS 109.




***Allowance
      for Doubtful Accounts Receivable***




We
      review
      the allowance for doubtful accounts for each reporting period based on a
      detailed analysis of our accounts receivable to determine that the amount of
      the
      allowance for doubtful accounts receivable is appropriately stated at the end
      of
      that period. In the analysis of accounts receivable, we primarily consider
      the
      age of the reseller’s or customer's receivable and also consider the
      creditworthiness of the reseller or customer, the economic conditions of the
      customer's industry, and general economic conditions, among other factors.
      If
      payment is not made timely, we contact the customer or reseller to attempt
      to
      obtain payment. If this is not successful, we institute other collection
      practices such as generating collection letters, involving our sales
      representatives and ultimately terminating the customer’s or reseller’s access
      to future upgrades, licenses and customer support and taking legal action as
      permitted in the contracts. When we determine collection is not expected, the
      receivable is written off against the allowance for doubtful
      accounts.





21







***Research
      and Development***




Through
      September 30, 2006, all research and development expenditures have been expensed
      as incurred. Based on our product development process and technological
      feasibility, the date at which capitalization of development costs may begin
      is
      established upon completion of a working model. Costs incurred between
      completion of the working model and the point at which the product is ready
      for
      general release have been insignificant.





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





We
      develop products in the United States and license our products in the Americas,
      EMEA and APAC. As a result, our financial results could be affected by various
      factors, including changes in foreign currency exchange rates or weak economic
      conditions in foreign markets. As most sales are currently made in U.S. dollars,
      a strengthening of the dollar could make our products less competitive in
      foreign markets. Currently, a portion of our contracts are billed in euros.
      As
      our business matures in foreign markets, we may offer our products and services
      in certain other local currencies. To support our foreign operations, we have
      employees in certain international markets and therefore pay salaries and other
      expenses in foreign currencies. We are subject to foreign currency fluctuations,
      which may increase and may have an adverse affect on our company.





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





**Item
      4. Controls and Procedures.**





We
      maintain a set of disclosure controls and procedures that are designed to ensure
      that information required to be disclosed by us in the reports filed by us
      under
      the Securities Exchange Act of 1934, as amended (Exchange Act) is recorded,
      processed, summarized and reported within the time periods specified in the
      SEC’s rules and forms. We carried out an evaluation, under the supervision and
      with the participation of our management, including our President and Chief
      Executive Officer and our Chief Financial Officer and Treasurer, of the
      effectiveness of the design and operation of our disclosure controls and
      procedures as of September 30, 2006 pursuant to Rule 13a-15(b) of the Exchange
      Act. Based on that evaluation, our President and Chief Executive Officer and
      our
      Chief Financial Officer and Treasurer concluded that our disclosure controls
      and
      procedures were not effective due to the material weakness described
      below.





A
      material weakness is a significant deficiency (within the meaning of the Public
      Company Accounting Oversight Board (PCAOB) Auditing Standard No. 2) or
      combination of significant deficiencies that result in more than a remote
      likelihood that a material misstatement of the annual or interim financial
      statements will not be prevented or detected.





Subsequent
      to the three months ended September 30, 2006, it was determined that our
      accounting staff did not initially complete all their contract review steps
      and
      recalculations related to amounts recognized in revenue for the three months
      ended September 30, 2006, resulting in an understatement of product revenues
      reported to management for the quarter. The errors were identified and corrected
      prior to the issuance on October 23, 2006 of our financial results for the
      three
      and nine months ended September 30, 2006. We also performed additional analyses
      and other post-quarter closing procedures to ensure our financial statements
      were prepared in accordance with accounting principles generally accepted in
      the
      United States. We have implemented changes to ensure all steps in the review
      of
      contracts will be completed monthly. Accordingly, we believe that the
      accompanying Condensed Consolidated Financial Statements included in this report
      fairly present, in all material respects, our financial condition, results
      of
      operations and cash flows for the periods presented.





Except
      for the remedial procedures described above, there have been no changes in
      our
      internal control over financial reporting that occurred during the three months
      ended September 30, 2006 that have materially affected, or are reasonably likely
      to materially affect, our internal control over financial reporting. ****








22





PART
      II.
      OTHER INFORMATION





**Item
      1. Legal Proceedings.**




The
      information set forth in Note 5 to the Condensed Consolidated Financial
      Statements included in Part I, Item 1 of this report is incorporated herein
      by
      reference.





**Item
      1A. Risk Factors.**





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





**We
      face risks from the impact of being classified as an “Accelerated
      Filer”**





An
      accelerated filer is defined by the SEC as a public company with public float
      greater than $75 million as of the end of its second fiscal quarter and
      satisfying certain other requirements. Due to our public float exceeding $75
      million as of June 30, 2006, we anticipate that we will be classified by the
      SEC
      as an accelerated filer as of December 31, 2006, and therefore the mandatory
      compliance date for the management report on internal control over financial
      reporting requirement and the related accounting firm report requirement under
      Section 404 of the Sarbanes-Oxley Act of 2002 will be December 31, 2006.
      Complying with the requirements of Section 404 of the Sarbanes-Oxley Act as
      of
      December 31, 2006 will redirect some of management’s focus and funding for the
      current year.





While
      we
      anticipate being able to fully implement the requirements relating to internal
      controls and all other aspects of Section 404 by our compliance deadline, we
      cannot be certain as to the timing of completion of our evaluation, testing
      and
      remediation actions or the impact of the same on our operations. If we are
      not
      able to implement the requirements of Section 404 in a timely manner or with
      adequate compliance, we might be subject to sanctions or investigation by
      regulatory authorities, including the SEC. In addition, we may be required
      to
      incur a substantial financial investment to comply with the requirements of
      Section 404.





**Item
      6. Exhibits.**





(a)
            Exhibits





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





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





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





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





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





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








23














**SIGNATURES**





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





Interactive
                Intelligence, Inc.(Registrant)Date:
                November 14, 2006
            By/s/
                Stephen R. HeadStephen
                R. Head*Chief
                Financial Officer, Vice President of Finance and**Administration,
                Secretary and Treasurer**(Principal
                Financial Officer and Principal Accounting
                Officer)*





24