** **

**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

 

**Washington,D.C. 20549**

 

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**FORM 10-Q**

 
| **(Mark One)**                                                                                                                                                                                                     |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                                                                                                                                                                                                               |   |
| **ý**                                                                                                                                                                                                         | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF  THE SECURITIES EXCHANGE ACT OF 1934** |
|                                                                                                                                                                                                               |   |
| **For the quarterly period ended June 30, 2004**                                                                                                                                                              |
|                                                                                                                                                                                                               |   |
| **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**

 

**INTERACTIVEINTELLIGENCE, INC.**

(Exact name of registrant as specifiedin its charter)

 

| **Indiana**                                                     |   | **35-1933097**                     |
|-----------------------------------------------------------------|--------|------------------------------------|
| (State or other jurisdiction of  incorporation or organization) |   | (IRS Employer Identification  No.) |
|                                                            |   |                               |
| **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 reportsrequired to be filed by Section 13 or 15(d) of the Securities Exchange Actof 1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject to suchfiling requirements for the past 90 days.

 

Yes ý    Noo   

 

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

 

Yeso    Noý   

 

The number of shares of common stock outstanding on July 30, 2004was 15,871,832.

 

 

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TABLE OF CONTENTS

 
| PART I. FINANCIAL INFORMATION |                                                                                                                         |
|-------------------------------|------------------------------------------------------------------------------------------------------------------------------|
|                          |                                                                                                                         |
| Item 1.                       | Condensed  Consolidated Balance Sheets as of June 30, 2004 (unaudited) and  December 31, 2003                      |   |
|                          |                                                                                                                         |   |
|                          | Condensed  Consolidated Statements of Operations for the three and six months ended  June 30, 2004 and 2003 (unaudited) |   |
|                          |                                                                                                                         |   |
|                          | Condensed  Consolidated Statement of Shareholders’ Equity for the six months ended  June 30, 2004 (unaudited)      |   |
|                          |                                                                                                                         |   |
|                          | Condensed  Consolidated Statements of Cash Flows for the six months ended June 30,  2004 and 2003 (unaudited)           |   |
|                          |                                                                                                                         |   |
|                          | Notes to Condensed Consolidated Financial Statements (unaudited)                                                             |   |
|                          |                                                                                                                         |   |
| Item 2.                       | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                                  |   |
|                          |                                                                                                                         |   |
| Item 3.                       | Quantitative  and Qualitative Disclosures About Market Risk                                                                  |   |
|                          |                                                                                                                         |   |
| Item 4.                       | Controls  and Procedures                                                                                                     |   |
|                          |                                                                                                                         |   |
| PART II. OTHER INFORMATION    |                                                                                                                         |
|                          |                                                                                                                         |   |
| Item 1.                       | Legal Proceedings                                                                                                            |   |
|                          |                                                                                                                         |   |
| Item 4.                       | Submission of Matters to a Vote of Security  Holders                                                                         |   |
|                          |                                                                                                                         |   |
| Item 6.                       | Exhibits and Reports on Form 8-K                                                                                             |   |
|                          |                                                                                                                         |   |
| SIGNATURES                    |                                                                                                                         |

 

2

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**PART I. FINANCIAL INFORMATION**

 

**Item1****. Condensed Consolidated Financial Statements andFootnotes.**

 

**Interactive Intelligence, Inc.**

 

**Condensed Consolidated Balance Sheets**

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

 
|                                                                                                                                                                          |   | **June 30,  2004** |   | **December 31,  2003** |   |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-------------------------|--------|-----------------------------|--------|
|                                                                                                                                                                          |   |                    |   |
|                                                                                                                                                                          |   | **(unaudited)**         |   |                        |   |
| **Assets**                                                                                                                                                                    |   |                    |   |                        |   |
| Current assets:                                                                                                                                                               |   |                    |   |                        |   |
| Cash and cash equivalents                                                                                                                                                     |   | $                       | 15,006 |                        | $      | 12,461 |   |
| Short-term investments                                                                                                                                                        |   | —                  |   | 3,008                       |   |
| Account receivable, net of allowance for  doubtful accounts of $303 in 2004 and $354 in 2003                                                                                  |   | 8,483                   |   | 8,956                       |   |
| Prepaid expenses                                                                                                                                                              |   | 1,912                   |   | 1,958                       |   |
| Other current assets                                                                                                                                                          |   | 223                     |   | 418                         |   |
| Total current assets                                                                                                                                                          |   | 25,624                  |   | 26,801                      |   |
| Property and equipment, net                                                                                                                                                   |   | 4,770                   |   | 5,857                       |   |
| Other assets, net                                                                                                                                                             |   | 590                     |   | 601                         |   |
| Total assets                                                                                                                                                                  |   | $                       | 30,984 |                        | $      | 33,259 |   |
|                                                                                                                                                                          |   |                    |   |                        |   |
| **Liabilities and  Shareholders’ Equity**                                                                                                                                |   |                    |   |                        |   |
| Current liabilities:                                                                                                                                                          |   |                    |   |                        |   |
| Line of credit                                                                                                                                                                |   | $                       | 3,000  |                        | $      | 2,800 |   |
| Accounts payable and accrued liabilities                                                                                                                                      |   | 4,490                   |   | 4,544                       |   |
| Accrued compensation and related expenses                                                                                                                                     |   | 1,217                   |   | 1,349                       |   |
| Deferred software revenues                                                                                                                                                    |   | 6,057                   |   | 8,745                       |   |
| Deferred services revenues                                                                                                                                                    |   | 11,886                  |   | 12,030                      |   |
| Total current liabilities                                                                                                                                                     |   | 26,650                  |   | 29,468                      |   |
| Shareholders’ equity:                                                                                                                                                    |   |                    |   |                        |   |
| Preferred stock, no par value: 10,000,000  authorized; no shares issued and outstanding                                                                                       |   | —                  |   | —                      |   |
| Common stock, $0.01 par value; 100,000,000  authorized; 15,857,938 issued and outstanding at June 30, 2004,  15,755,477 issued and outstanding at December 31, 2003 |   | 158                     |   | 157                         |   |
| Additional paid-in capital                                                                                                                                                    |   | 65,007                  |   | 64,696                      |   |
| Accumulated other comprehensive income                                                                                                                                        |   | 87                      |   | 280                         |   |
| Accumulated deficit                                                                                                                                                           |   | (60,918                 | )      | (61,342                     | )      |
| Total shareholders’ equity                                                                                                                                               |   | 4,334                   |   | 3,791                       |   |
| Total liabilities and shareholders’ equity                                                                                                                               |   | $                       | 30,984 |                        | $      | 33,259 |   |

 

See Notes to Condensed Consolidated FinancialStatements

 

3

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**InteractiveIntelligence, Inc.**

 

**CondensedConsolidated Statements of Operations (unaudited)**

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

** **
|                                                 |   | **Three  Months Ended  June 30,** |   | **Six Months  Ended  June 30,** |       |
|------------------------------------------------------|--------|----------------------------------------|--------|--------------------------------------|------------|
|                                                 |   |                                   |   |
|                                                 |   | **2004**                               |   | **2003**                             | ** ** | **2004** | ** ** | **2003** | ** ** |
| Revenues:                                            |   |                                   |   |                                 |       |   |   |   |   |
| Software                                             |   | $                                      | 7,257  |                                 | $          | 5,772 |   | $ | 14,250 |   | $ | 14,393 |   |
| Services                                             |   | 6,384                                  |   | 6,335                                |       | 13,097 |   | 12,098 |   |
| Total revenues                                       |   | 13,641                                 |   | 12,107                               |       | 27,347 |   | 26,491 |   |
| Cost of revenues:                                    |   |                                   |   |                                 |       |   |   |   |   |
| Software                                             |   | 400                                    |   | 325                                  |       | 893 |   | 617 |   |
| Services                                             |   | 2,775                                  |   | 3,254                                |       | 5,630 |   | 6,440 |   |
| Total cost of revenues                               |   | 3,175                                  |   | 3,579                                |       | 6,523 |   | 7,057 |   |
| Gross profit                                         |   | 10,466                                 |   | 8,528                                |       | 20,824 |   | 19,434 |   |
| Operating expenses:                                  |   |                                   |   |                                 |       |   |   |   |   |
| Sales and marketing                                  |   | 5,076                                  |   | 4,910                                |       | 10,104 |   | 10,117 |   |
| Research and development                             |   | 3,258                                  |   | 3,472                                |       | 6,536 |   | 6,967 |   |
| General and administrative                           |   | 1,722                                  |   | 1,356                                |       | 3,593 |   | 2,812 |   |
| Restructuring and other charges                      |   | 85                                     |   | 2,690                                |       | 101 |   | 3,138 |   |
| Total operating expenses                             |   | 10,141                                 |   | 12,428                               |       | 20,334 |   | 23,034 |   |
| Operating income (loss)                              |   | 325                                    |   | (3,900                               | )          | 490 |   | (3,600 | ) |
| Interest income, net                                 |   | 25                                     |   | 43                                   |       | 32 |   | 96 |   |
| Income (loss) before income taxes                    |   | 350                                    |   | (3,857                               | )          | 522 |   | (3,504 | ) |
| Income taxes                                         |   | 46                                     |   | 43                                   |       | 98 |   | 96 |   |
| Net income (loss)                                    |   | $                                      | 304    |                                 | $          | (3,900 | ) | $ | 424 |   | $ | (3,600 | ) |
|                                                 |   |                                   |   |                                 |       |   |   |   |   |
| Net income (loss) per share:                         |   |                                   |   |                                 |       |   |   |   |   |
| Basic                                                |   | $                                      | 0.02   |                                 | $          | (0.25 | ) | $ | 0.03 |   | $ | (0.23 | ) |
| Diluted                                              |   | 0.02                                   |   | (0.25                                | )          | 0.03 |   | (0.23 | ) |
|                                                 |   |                                   |   |                                 |       |   |   |   |   |
| Shares used to compute net income (loss) per  share: |   |                                   |   |                                 |       |   |   |   |   |
| Basic                                                |   | 15,845                                 |   | 15,600                               |       | 15,826 |   | 15,582 |   |
| Diluted                                              |   | 16,735                                 |   | 15,600                               |       | 16,716 |   | 15,582 |   |

 

See Notes to Condensed Consolidated FinancialStatements

 

4

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**InteractiveIntelligence, Inc.**

 

**CondensedConsolidated Statement of Shareholders’ Equity (unaudited)**

**(in thousands)**

 
|                                              |   | **Common  Stock** |   | **Additional  Paid-inCapital** |   | **Accum.  Other  ComprehensiveIncome** |   | **AccumulatedDeficit** |   | **Total** |   |
|---------------------------------------------------|--------|-------------------|--------|--------------------------------|--------|----------------------------------------|--------|------------------------|--------|-----------|--------|
|                                              |   |              |   |                           |   |                                   |
|                                              |   | **Shares**        |   | **Amount**                     |   |                                   |   |                   |   |
|                                              |   |              |   |                           |   |                                   |   |                   |   |      |   |   |   |   |   |   |   |   |
| Balances, December 31, 2003                  |   | 15,755            |   | $                              | 157    |                                   | $      | 64,696                 |   | $         | 280    |   | $ | (61,342 | ) | $ | 3,791 |   |
|                                              |   |              |   |                           |   |                                   |   |                   |   |      |   |   |   |
| Issuances of common stock                         |   | 47                |   | —                         |   | 149                                    |   | —                 |   | —    |   | 149 |   |
| Exercise of stock options                         |   | 56                |   | 1                              |   | 152                                    |   | —                 |   | —    |   | 153 |   |
| Amortization of deferred stock-based compensation |   | —            |   | —                         |   | 10                                     |   | —                 |   | —    |   | 10 |   |
| Comprehensive income:                             |   |              |   |                           |   |                                   |   |                   |   |      |   |   |   |
| Foreign currency fluctuation                      |   | —            |   | —                         |   | —                                 |   | (193                   | )      | —    |   | (193 | ) |
| Net income                                        |   | —            |   | —                         |   | —                                 |   | —                 |   | 424       |   | 424 |   |
| Total comprehensive income                        |   | —            |   | —                         |   | —                                 |   | (193                   | )      | 424       |   | 231 |   |
|                                              |   |              |   |                           |   |                                   |   |                   |   |      |   |   |   |
| Balances, June 30, 2004                      |   | 15,858            |   | $                              | 158    |                                   | $      | 65,007                 |   | $         | 87     |   | $ | (60,918 | ) | $ | 4,334 |   |

 

See Notes to Condensed Consolidated FinancialStatements

 

5

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**InteractiveIntelligence, Inc.**

 

**CondensedConsolidated Statements of Cash Flows (unaudited)**

**(in thousands)**

 
|                                                                                             |   | **Six Months  Ended  June 30,** |   |
|--------------------------------------------------------------------------------------------------|--------|--------------------------------------|--------|
|                                                                                             |   |                                 |
|                                                                                             |   | **2004**                             |   | **2003** | ** ** |
| **Operating  activities:**                                                                       |   |                                 |   |   |   |
| Net income (loss)                                                                                |   | $                                    | 424    |   | $ | (3,600 | ) |
| Adjustments to reconcile net income (loss)  to net cash provided (used) by operating activities: |   |                                 |   |   |   |
| Depreciation                                                                                     |   | 1,670                                |   | 2,447 |   |
| Amortization of deferred stock-based  compensation                                               |   | 10                                   |   | 46 |   |
| Loss on disposal of fixed assets                                                                 |   | —                               |   | 539 |   |
| Changes in operating assets and  liabilities:                                                    |   |                                 |   |   |   |
| Accounts receivable                                                                              |   | 473                                  |   | 1,943 |   |
| Prepaid expenses                                                                                 |   | 46                                   |   | 610 |   |
| Other current assets                                                                             |   | 2                                    |   | (10 | ) |
| Other assets                                                                                     |   | 11                                   |   | (21 | ) |
| Accounts payable and accrued liabilities                                                         |   | (54                                  | )      | 1,422 |   |
| Accrued compensation and related expenses                                                        |   | (132                                 | )      | (52 | ) |
| Deferred software revenues                                                                       |   | (2,688                               | )      | (2,814 | ) |
| Deferred services revenues                                                                       |   | (144                                 | )      | 1,505 |   |
| Net cash provided (used) by operating  activities                                                |   | (382                                 | )      | 2,015 |   |
|                                                                                             |   |                                 |   |   |   |
| **Investing  activities:**                                                                       |   |                                 |   |   |   |
| Purchases of property and equipment                                                              |   | (583                                 | )      | (2,412 | ) |
| Sales of available-for-sale investments                                                          |   | 3,008                                |   | 6,368 |   |
| Net cash provided by investing activities                                                        |   | 2,425                                |   | 3,956 |   |
|                                                                                             |   |                                 |   |   |   |
| **Financing  activities:**                                                                       |   |                                 |   |   |   |
| Proceeds from line of credit, net                                                                |   | 200                                  |   | — |   |
| Proceeds from issuance of common stock                                                           |   | 149                                  |   | 167 |   |
| Proceeds from stock options exercised                                                            |   | 153                                  |   | 2 |   |
| Net cash provided by financing activities                                                        |   | 502                                  |   | 169 |   |
|                                                                                             |   |                                 |   |   |   |
| Net increase in cash and cash equivalents                                                        |   | 2,545                                |   | 6,140 |   |
| Cash and cash equivalents, beginning of  period                                                  |   | 12,461                               |   | 5,913 |   |
| Cash and cash equivalents, end of period                                                         |   | $                                    | 15,006 |   | $ | 12,053 |   |
|                                                                                             |   |                                 |   |   |   |
| Cash paid for interest                                                                           |   | $                                    | 14     |   | $ | 6 |   |
| Cash paid for taxes                                                                              |   | 4                                    |   | 2 |   |

 

See Notes to Condensed Consolidated Financial Statements

 

6

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**Interactive Intelligence, Inc.**

** **

**Notes to Consolidated Financial Statements**

**(unaudited)**

 

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

 

Interactive Intelligence, Inc. (the “Company”) is a leading provider ofsoftware applications for contact centers and is leveraging that leadershipposition to provide mission critical voice over Internet protocol (VoIP)applications to enterprises. The Company sells into four distinct markets, allof whose needs are increasing for VoIP-based systems:

 

•                  Contact Centers

•                  Enterprise IPTelephony

•                  UnifiedCommunications, and

•                  Self-serviceAutomation.

 

The Company’s principal competitors are hardware vendors who offerproprietary approaches using a combination of phone systems, call distributors,voicemail systems, and interactive voice response (IVR) systems equipment. TheCompany offers a software solution based on Microsoft Windows that resides on acustomer’s network and uses an open Session Initiation Protocol (SIP) for VoIPnetworking. This open approach typically results in lower overall costs forphone devices, system maintenance, and customer networking. The Company’ssoftware applications are also pre-integrated into many popular businessapplications such as financial, customer relationship management (CRM) andenterprise resource planning (ERP) software, thereby automating and trackingbusiness transactions to customer interactions. The Company is best known forits bundled suite of contact center applications that includes multi-mediacustomer contact for phone calls, Web chat, Web callback, e-mail queuing,customer defined queues, and integrated speech recognition applications.

 

In June 2004, the Company released the next version of itsproduct, version 2.3, which underlies the Customer Interaction Center (CIC),Enterprise Interaction Center (EIC) and other applications. This versionaddresses reliability and scalability of the applications and provides forsimplified installation and maintenance of all of the Company’s softwareapplications.

 

Principal operations of the Company commenced during 1997. The Companycurrently markets its software applications in: the Americas; Europe, MiddleEast and Africa (EMEA); and Australia and other Asia/Pacific countries (APAC).Besides its corporate headquarters in Indianapolis, Indiana, the Company hasestablished wholly-owned subsidiaries in Australia, France, the Netherlands andthe United Kingdom. In addition, the Company has branch offices in Canada,Germany, Hong Kong, Japan, Korea, Malaysia, Singapore and Sweden.

 

On July 1, 2004, the Company formed a wholly-owned subsidiary,Vonexus, Inc. (Vonexus), which is responsible for the development, marketingand distribution of the Company’s EIC application. EIC is the Company’sstandards-based all-software IP PBX that is offered as part of a completetelephony solution for Microsoft-centric small and medium-sized businesses.

 

The accompanying unaudited financial statements have been prepared inconformity with accounting principles generally accepted in the United Statesof America for interim financial information and with the instructions for Form10-Q and Article 10 of Regulation S-X. Accordingly, certain informationand footnote disclosures normally included in financial statements prepared inaccordance with accounting principles generally accepted in the United Statesof America have been condensed, or omitted, pursuant to the rules and regulationsof the Securities and Exchange Commission. In our opinion, the statementsinclude all adjustments necessary (which are of a normal and recurring nature)for the fair presentation of the results of the interim periods presented.

 

The balance sheet at December 31, 2003 has been derived from theaudited financial statements at that date but does not include all of theinformation and footnotes required by accounting principles generally acceptedin the United States of America for complete financial statements.

 

These financial statements should be read in conjunction with ouraudited consolidated financial statements for the year ended December 31,2003, included in the Company’s Form 10-K for the year

 

7

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ended December 31, 2003, filed with the Securities and ExchangeCommission on March 25, 2004. Our results of operations for any interimperiod are not necessarily indicative of the results of operations for anyother interim period or for a full fiscal year.

 

**2.****                                      NetIncome Per Common Share**

 

Basic net income per share is calculated based on the weighted-averagenumber of outstanding common shares in accordance with Financial AccountingStandards Board (FASB) Statement No. 128, *Earnings per Share*. Diluted net income pershare is calculated based on the weighted-average number of outstanding commonshares plus the effect of dilutive potential common shares.

 

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

 
|                                                     |   | **Three  Months Ended  June 30,** |   | **Six Months  Ended  June 30,** |   |
|----------------------------------------------------------|--------|----------------------------------------|--------|--------------------------------------|--------|
|                                                     |   |                                   |   |
|                                                     |   | **2004**                               |   | **2003**                             |   | **2004** |   | **2003** |   |
|                                                     |   |                                   |   |                                 |   |   |   |   |   |
| Net income (loss) (A)                                    |   | $                                      | 304    |                                 | $      | (3,900 | ) | $ | 424 |   | $ | (3,600 | ) |
|                                                     |   |                                   |   |                                 |   |   |   |   |   |
| Weighted average outstanding shares of  common stock (B) |   | 15,845                                 |   | 15,600                               |   | 15,826 |   | 15,582 |   |
| Dilutive effect of options to purchase  common stock     |   | 890                                    |   | —                               |   | 890 |   | — |   |
| Common stock and common stock equivalent  shares (C)     |   | 16,735                                 |   | 15,600                               |   | 16,716 |   | 15,582 |   |
|                                                     |   |                                   |   |                                 |   |   |   |   |   |
| Net income (loss) per share:                             |   |                                   |   |                                 |   |   |   |   |   |
| Basic (A/B)                                              |   | $                                      | 0.02   |                                 | $      | (0.25 | ) | $ | 0.03 |   | $ | (0.23 | ) |
| Diluted (A/C)                                            |   | 0.02                                   |   | (0.25                                | )      | 0.03 |   | (0.23 | ) |

 

The Company’s calculation of diluted net income per share for the threemonths and six months ended June 30, 2004 excludes options to purchase 1.2million shares of common stock with exercise prices ranging from $5.79 to$50.50 as their effect would be antidilutive. The Company’s calculation ofdiluted net loss per share for the three and six months ended June 30,2003 excludes all potential common shares as the effect would be antidilutive.

 

**3.****                                      Stock-BasedCompensation**

 

The Company applies the intrinsic-value-based method of accountingprescribed by Accounting Principles Board (APB) Opinion No. 25, *Accountingfor Stock Issued to Employees*, and related interpretations includingFASB Interpretation No. 44, *Accounting for Certain Transactions involving StockCompensation, an interpretation of APB Opinion No. 25*, to accountfor its fixed-plan stock options. Under this method, compensation expense isrecorded on the date of grant only if the current market price of theunderlying stock exceeds the exercise price. FASB Statement No. 123, *Accounting for Stock-Based Compensation*and FASB Statement No. 148, *Accounting for Stock-Based Compensation – Transitionand Disclosure - an amendment of FASB Statement No. 123*, establishedaccounting and disclosure requirements using a fair-value-based method ofaccounting for stock-based employee compensation plans. As permitted byexisting accounting standards, the Company has elected to continue to apply theintrinsic-value-based method of accounting described above, and has adoptedonly the disclosure requirements of FASB Statement No. 123, as amended.

 

For purposes of pro forma disclosures, theestimated fair value of the options is amortized to expense on a straight-linebasis over the options’ vesting period. The table below illustrates the effecton net income (loss) and net income (loss) per share if the Company had appliedthe fair value recognition provisions of FASB Statement No. 123 to stock-basedemployee compensation (in thousands except per share amounts).

 

8

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|                                                                                                                                |   | **Three  Months Ended  June 30,** |   | **Six Months  Ended  June 30,** |   |
|-------------------------------------------------------------------------------------------------------------------------------------|--------|----------------------------------------|--------|--------------------------------------|--------|
|                                                                                                                                |   |                                   |   |
|                                                                                                                                |   | **2004**                               |   | **2003**                             |   | **2004** |   | **2003** |   |
|                                                                                                                                |   |                                   |   |                                 |   |   |   |   |   |
| Net income (loss), as reported                                                                                                      |   | $                                      | 304    |                                 | $      | (3,900 | ) | $ | 424 |   | $ | (3,600 | ) |
| Add: Stock-based compensation expense  included in reported net income, net of related tax effects                                  |   | 7                                      |   | 23                                   |   | 10 |   | 46 |   |
| Deduct: Total stock-based compensation  expense determined under fair value based method for all awards, net of  related tax effect |   | (855                                   | )      | (1,381                               | )      | (1,607 | ) | (2,770 | ) |
| Pro forma net loss                                                                                                                  |   | $                                      | (544   | )                                    | $      | (5,258 | ) | $ | (1,173 | ) | $ | (6,324 | ) |
|                                                                                                                                |   |                                   |   |                                 |   |   |   |   |   |
| Net income (loss) per share:                                                                                                        |   |                                   |   |                                 |   |   |   |   |   |
| Basic – as reported                                                                                                            |   | $                                      | 0.02   |                                 | $      | (0.25 | ) | $ | 0.03 |   | $ | (0.23 | ) |
| Diluted – as reported                                                                                                          |   | $                                      | 0.02   |                                 | $      | (0.25 | ) | $ | 0.03 |   | $ | (0.23 | ) |
| Basic – pro forma                                                                                                              |   | $                                      | (0.03  | )                                    | $      | (0.34 | ) | $ | (0.07 | ) | $ | (0.41 | ) |
| Diluted – pro forma                                                                                                            |   | $                                      | (0.03  | )                                    | $      | (0.34 | ) | $ | (0.07 | ) | $ | (0.41 | ) |

 

**4.****                                      Concentrationof Credit Risk**

 

One reseller represented 15% of accounts receivableas of June 30, 2004 and one customer represented approximately 10% oftotal revenues for the six months ended June 30, 2003.

 

**5.****                                      Contingencies**

 

From time to time the Company has received claims from competitors andother technology providers claiming that the Company’s technology infringestheir respective proprietary rights. One such claim has resulted in a legalproceeding being filed against the Company, which is described below. Inaddition, the Company is involved in certain legal proceedings in the ordinarycourse of conducting its business. The Company believes these claims and legalproceedings can be resolved without a material adverse effect on its business,financial condition or results of operations; however, the Company cannotprovide assurance as to the outcome. Litigation in general, and intellectualproperty litigation in particular, can be expensive and disruptive to normalbusiness operations. Moreover, the results of complex legal proceedings aredifficult to predict.

 

In 2002, the Company received a letter from a consulting firm that hasbeen retained by a telecommunication technology provider to develop andimplement a licensing program based on the technology provider’s patents. Theconsulting firm believes that the Company has infringed on the technologyprovider’s propriety rights and therefore feels that a licensing agreementbetween the Company and the technology provider is appropriate. The Companybelieves that it did not infringe on the technology provider’s proprietaryrights; however, because of the cost of defending such a matter in court, theCompany did offer a settlement. The technology provider has not accepted theCompany’s offer of settlement. The Company does not believe a settlement is probableand the term over which a settlement would be recognized is uncertain. TheCompany may be required to defend its position in a court of law should alawsuit be filed. Because of the facts presented above, the Company has notrecorded an accrual for any settlement in this matter. The Company cannotprovide assurance as to the outcome.

 

In 2002, the Company received a letter from one of its resellersrequesting indemnification related to a request that the reseller had receivedfor indemnification from a customer. The customer had received a letter from athird party indicating that the customer may be infringing patents held by thethird party. To date, the Company’s patent counsel has not determined thevalidity or the applicability of these patents as they relate to the Company’sproducts or whether the reseller is entitled to indemnification. The Companybelieves that this matter can be resolved without a material adverse effect onits business, financial condition or results of operations; however, theCompany cannot provide assurance as to the outcome.

 

9

----

 

On September 30, 2003, Recursion Software, Inc. filed suit inDallas County Court in Dallas, Texas against the Company alleging breach ofcontract and money due under claims of quantum meruit, unjust enrichment andinfringement. Recursion claims that the Company incorporated Recursion softwareinto one of its products in breach of the underlying license. No dollar amounthas been stated in the action. The Company believes that it has strong defensesto the claims and intends to vigorously defend against the action. The Companybelieves that this matter can be resolved without a material adverse effect onits business, financial condition or results of operations; however, theCompany cannot provide assurance as to the outcome.

 

In 2002, the Company received a notification from the French governmentas 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 toValue Added Tax (VAT) and corporation taxes in addition to what has previouslybeen paid and accrued. As of June 30, 2004, the assessment related to VATwas approximately $2.8 million and the assessment related to corporation taxeswas approximately $366,000. The Company’s tax counsel has assessed thepossibility of the Company paying the assessment related to VAT as remote andthe assessment related to corporation taxes as reasonably possible; the Companyhas not accrued for these amounts. The Company is appealing the assessments,but cannot assure you that these matters will be resolved without litigation orthat it will not have to pay some or all of the assessments.

 

**6.****                                      RestructuringCharges**

 

In February 2003, the Company announced its plan to downsize andreorganize resources in EMEA. The French office was significantly affected,with most positions moved or eliminated. The Company determined that theseverance payments and related legal fees incurred qualified as restructuringcosts in accordance with FASB Statement No. 146, *Accounting for Costs Associated with Exit or Disposal Activities*.

 

Effective April 1, 2003, the Company moved its worldwideheadquarters to a new building in Indianapolis, Indiana and allIndianapolis-based employees, equipment and furniture were relocated to the newfacility. The majority of the lease on the previous headquarters has expired,however the Company continues to owe lease payments on a small portion of theprevious headquarters through February 12, 2005. The Company determinedthat the remaining lease payments as of April 1, 2003 for the previousheadquarters, net of sublease income, qualified as an exit cost and wasrecognized in accordance with SFAS 146 as restructuring charges. The Companydoes not anticipate additional restructuring charges related to the relocationof its worldwide headquarters.

 

The Company has ten former employees from its French office with whomit has not reached agreement regarding severance. The Company has recorded aliability for the estimated severance for those employees in accordance withFASB Statement No. 146. The Company could incur additional expenses related tothese employees for legal fees and for additional severance costs when a settlementis reached.

 

The Company recognized restructuring charges in accordance with FASBStatement No. 146 of $85,000 and $2.7 million for the three months endedJune 30, 2004 and 2003, respectively, and $101,000 and $3.1 million forthe six months ended June 30, 2004 and 2003, respectively.

 

A summary of the beginning accrued restructuring charges, expensedamount, cash payments and the ending accrued restructuring charges for the sixmonths ended June 30, 2004 is presented below (in thousands).

 

10

----

 

 
|               |   | **Beginning  Balance** |   | **Expense** |   | **Cash  Payments** |   | **Ending  Balance** |   |
|--------------------|--------|------------------------|--------|-------------|--------|--------------------|--------|---------------------|--------|
|               |   |                   |   |        |   |
|               |   |                   |   |        |   |               |   |                |   |
| EMEA restructuring |   | $                      | 549    |        | $      | 101                |   | $                   | (207   | ) | $ | 443 |   |
| Headquarters       |   | 267                    |   | —      |   | (261               | )      | 6                   |   |
| Total              |   | $                      | 816    |        | $      | 101                |   | $                   | (468   | ) | $ | 449 |   |

 

**Item2****. Management’s Discussion and Analysis of FinancialCondition 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, asamended and Section 21E of the Securities Exchange Act of 1934, asamended) that involve risks and uncertainties which may cause actual results todiffer materially from those predicted in the forward-looking statements.Forward-looking statements can often be identified by their use of such verbsas “expects,” “anticipates,” and “believes” or similar verbs or conjugations ofsuch verbs. If any of our assumptions on which the statements are based proveincorrect or should unanticipated circumstances arise, our actual results couldmaterially differ from those anticipated by such forward-looking statements.The differences could be caused by a number of factors or combination offactors, including, but not limited to, the “Factors that may affect our futureoperating results” described herein and the Risk Factors described in ourSecurities and Exchange Commission filings, including the Form 10-K filingfor the year ended December 31, 2003.

 

### **Overview**

### ** **

We are a leading provider of software applications for contact centersand hope to leverage that leadership position to provide mission critical VoIPapplications to enterprises. Our customers are in a wide variety of fieldsincluding financial institutions, government, healthcare and retail, among others.We are a global software provider with presence in: the Americas; Europe,Middle East and Africa (EMEA); and Australia and other Asia/Pacific countries(APAC).

 

### **Financial Highlights**

### ** **

In the initial years after we began licensing our software applications,our revenue growth was substantial. In 2002 and 2003, we saw a decrease inworldwide spending on technology given the global economic slowdown, and as aresult, our revenue growth has diminished.

 

We believe that during the economic downturn and resulting decrease intechnology spending, it became harder to market our products to new customers.Companies delayed changes to their systems and continued to use technology thatthey had in place. However, we believe that once companies have implemented oursoftware and the personnel at these companies experience the capabilities andefficiencies of our software, these companies are increasing their technologyspending for our software. Future licensing to new customers is dependent onthe economy and whether companies will allocate their resources to upgradetheir systems.

 

Revenues recognized in the three months ended June 30, 2004increased over $1.5 million from revenues for the three months endedJune 30, 2003. Total revenues for the six months ended June 30, 2004increased $856,000 over the six months ended June 30, 2003. Softwarerevenues of $7.3 million for the three months ended June 30, 2004 were upnearly $1.5 million over the three months ended June 30, 2003. Beginningin the first quarter of 2004, we began offering perpetual licenses to our newcustomers and therefore the recognition of revenue on new contracts signed in2004 was accelerated compared to how revenue was recognized under annuallyrenewable licenses in 2003.

 

The information below shows our total revenues and percentage growthfrom the previous year since sales commenced (revenues in millions).

 

11

----

 
| **Year**                          |   | **Revenues** |   | **% Growth** |   |
|-----------------------------------|--------|--------------|--------|--------------|--------|
| 2004 (through June 30, 2004) |   | $            | 27.3   |         | 3      | %(1) |
| 2003                              |   | 51.5         |   | 8            |   |
| 2002                              |   | 47.8         |   | 0            |   |
| 2001                              |   | 47.9         |   | 76           |   |
| 2000                              |   | 27.3         |   | 43           |   |
| 1999                              |   | 19.1         |   | 112          |   |
|                                   |        |              |        |              |        |  |

 

----

(1)          Percentgrowth shown is for the six months ended June 30, 2004 compared to the sixmonths ended June 30, 2003.

 

Operating expenses for the three and six months ended June 30,2004 decreased $2.3 million and $2.7 million, respectively, compared to thethree and six months ended June 30, 2003. These decreases were primarilydue to restructuring charges recognized in 2003 related to the reorganizationof our European operations and the relocation of our world-wide headquartersand also due to a slight decrease in research and development expenses in 2004compared to 2003 related to a slight reduction in headcount and lowerdepreciation expense. These decreases were partially offset by an increase ingeneral and administrative expenses in 2004 due mostly to higher legal expensesrelated to the hiring of a general counsel and increased efforts to resolvelitigation and other claims against us.

 

We had approximately $15.0 million of cash and cash equivalents as ofJune 30, 2004. We had borrowings under a line of credit of $3.0 million asof June 30, 2004, which has since been repaid in full. We believe that asour revenues grow, the collection of our accounts receivable improves and ourexpenses remain controlled, we will increase our liquidity and positionourselves for growth in the future. If revenues remain stagnant or decrease, orif we are unable to collect our outstanding account receivable balances fromour customers, our liquidity position may weaken, which would result in theneed to raise capital, either through the capital markets or debt financings.

 

We have formed a new subsidiary, Vonexus, on July 1, 2004. Vonexuswill be focused on selling a complete IP-based phone system, includinghardware, to Microsoft-based small and medium-sized businesses. As a result ofthis new market focus, we expect to recognize additional sales and marketingexpenses in the third and fourth quarters of 2004. We may also incur additionalcosts of revenues related to hardware costs and, as a consequence, if Vonexussales become significant our gross profits as a percentage of revenues maydecline.

 

### **Historical Results of Operations**

### ** **

The following table presents certain financial data, derived from ourunaudited statements of operations, as a percentage of total revenues for theperiods indicated. The operating results for the three and six months endedJune 30, 2004 and 2003 are not necessarily indicative of the results thatmay be expected for the full year or for any future period.

 
|                              |   | **Three  Months Ended  June 30,** |   | **Six Months  Ended  June 30,** |   |
|-----------------------------------|--------|----------------------------------------|--------|--------------------------------------|--------|
|                              |   |                                   |   |
|                              |   | **2004**                               |   | **2003**                             |   | **2004** |   | **2003** |   |
| Revenues:                         |   |                                   |   |                                 |   |   |   |   |   |
| Software                          |   | 53                                     | %      | 48                                   | %      | 52 | % | 54 | % |
| Services                          |   | 47                                     |   | 52                                   |   | 48 |   | 46 |   |
| Total revenues                    |   | 100                                    |   | 100                                  |   | 100 |   | 100 |   |
| Cost of revenues:                 |   |                                   |   |                                 |   |   |   |   |   |
| Software                          |   | 3                                      |   | 3                                    |   | 3 |   | 2 |   |
| Services                          |   | 20                                     |   | 27                                   |   | 21 |   | 24 |   |
| Total cost of revenue             |   | 23                                     |   | 30                                   |   | 24 |   | 26 |   |
| Gross profit                      |   | 77                                     |   | 70                                   |   | 76 |   | 74 |   |
| Operating expenses:               |   |                                   |   |                                 |   |   |   |   |   |
| Sales and marketing               |   | 37                                     |   | 41                                   |   | 37 |   | 38 |   |
| Research and development          |   | 24                                     |   | 29                                   |   | 24 |   | 26 |   |
| General and administrative        |   | 13                                     |   | 11                                   |   | 13 |   | 11 |   |
| Restructuring and other charges   |   | 1                                      |   | 22                                   |   | — |   | 12 |   |
| Total operating expenses          |   | 75                                     |   | 103                                  |   | 74 |   | 87 |   |
| Operating income (loss)           |   | 2                                      |   | (33                                  | )      | 2 |   | (13 | ) |
| Interest income, net              |   | —                                 |   | —                               |   | — |   | — |   |
| Income (loss) before income taxes |   | 2                                      |   | (33                                  | )      | 2 |   | (13 | ) |
| Income taxes                      |   | —                                 |   | —                               |   | — |   | — |   |
| Net income (loss)                 |   | 2                                      | %      | (33                                  | )%     | 2 | % | (13 | )% |

 

12

----

 

**Comparison of Three and Six Months EndedJune 30, 2004 and 2003**

 

##### ***Revenues***

##### *** ***

## *Software Revenues*

|                         |   | **Three  Months Ended  June 30,** |       | **Six Months  Ended  June 30,** |       |
|------------------------------|--------|----------------------------------------|------------|--------------------------------------|------------|
|                         |   |                                   |       |
|                         |   | **2004**                               |       | **2003**                             |       | **2004** |   | **2003** |   |
|                         |   |                                   | ** ** | **($ in thousands)**                 | ** ** |   | ** ** |
| Software revenues            |   | $                                      | 7,257      |                                 | $          | 5,772 |   | $ | 14,250 |   | $ | 14,393 |   |
| Change from prior year       |   | 26                                     | %          | (25                                  | )%         | (1 | )% | (6 | )% |
| Percentage of total revenues |   | 53                                     | %          | 48                                   | %          | 52 | % | 54 | % |
|                              |        |                                        |            |                                      |            |  |  |  |  |  |  |  |  |  |

 

The increase in software revenues and percent of software revenues tototal revenues for the three months ended June 30, 2004 compared to thethree months ended June 30, 2003, was related primarily to an increase inthe percentage of perpetual license agreements we recognized in 2004. Beginningin the first quarter of 2004, we began offering perpetual licenses to our newcustomers and therefore the recognition of revenue on new contracts signed in2004 was accelerated compared to how revenue was recognized under annuallyrenewable licenses in 2003. Some customers prefer a perpetual license;therefore, the decision to offer customers perpetual licenses was a part ofother actions designed to improve our customer licensing process and may resultin the acceleration of revenue recognition. Forty-four percent of the softwarerevenues recognized in the three months ended June 30, 2004 were relatedto perpetual license agreements compared to 8% of the software revenues in thethree months ended June 30, 2003.

 

Entering into more perpetual license agreements had a similar effect onsoftware revenues for the six months ended June 30, 2004 compared tosoftware revenues for the six months ended June 30, 2003; however, werecognized approximately $3 million of software revenues in the first threemonths of 2003 related to a perpetual license agreement with one customer.Forty-one percent of the software revenues recognized in the six months endedJune 30, 2004 were related to perpetual license agreements compared to 22%of the software revenues in the six months ended June 30, 2003 (includingthe one large perpetual agreement during the first three months of 2003).

 

## *Services Revenues*

## * *

|                         |   | **Three  Months Ended  June 30,** |   | **Six Months  Ended  June 30,** |   |
|------------------------------|--------|----------------------------------------|--------|--------------------------------------|--------|
|                         |   |                                   |   |
|                         |   | **2004**                               |   | **2003**                             |   | **2004** |   | **2003** |   |
|                         |   |                                   |   | **($ in  thousands)**                |   |   |   |
| Services revenues            |   | $                                      | 6,384  |                                 | $      | 6,335 |   | $ | 13,097 |   | $ | 12,098 |   |
| Change from prior year       |   | 1                                      | %      | 43                                   | %      | 8 | % | 38 | % |
| Percentage of total revenues |   | 47                                     | %      | 52                                   | %      | 48 | % | 46 | % |
|                              |        |                                        |        |                                      |        |  |  |  |  |  |  |  |  |

 

Services revenues remained fairly constant for the three months endedJune 30, 2004 compared to the three months ended June 30, 2003.Support and maintenance revenues increased, due to increases in our growinginstalled base of customers and related payments of annual license renewal feesand ongoing maintenance from perpetual licenses, but were offset by a decreasein royalty income related to third party hardware sales and a decrease inprofessional services revenues.

 

13

----

 

The increase in services revenues for the six months endedJune 30, 2004 compared to the six months ended June 30, 2003 wasprimarily due to increases in our growing installed base of customers andrelated payments of annual license renewal fees and ongoing maintenance fromperpetual licenses. As we sign and install new customers, our services revenuesshould grow, if existing customers continue to renew licenses and pay formaintenance on our software applications. The percent of services revenues tototal revenues grew due to the decrease in software revenues (as describedabove) coupled with the increasing services revenues.

 

##### ***Cost ofRevenues***

##### *** ***

|                                       |   | **Three  Months Ended  June 30,** |   | **Six Months  Ended  June 30,** |   |
|--------------------------------------------|--------|----------------------------------------|--------|--------------------------------------|--------|
|                                       |   |                                   |   |
|                                       |   | **2004**                               |   | **2003**                             |   | **2004** |   | **2003** |   |
|                                       |   |                                   |   | **($ in thousands)**                 |   |   |   |
| Cost of revenues:                          |   |                                   |   |                                 |   |   |   |   |   |
| Software                                   |   | $                                      | 400    |                                 | $      | 325 |   | $ | 893 |   | $ | 617 |   |
| Services                                   |   | 2,775                                  |   | 3,254                                |   | 5,630 |   | 6,440 |   |
| Total cost of revenues                     |   | $                                      | 3,175  |                                 | $      | 3,579 |   | $ | 6,523 |   | $ | 7,057 |   |
| Change from prior year                     |   | (11                                    | )%     | 17                                   | %      | (8 | )% | 11 | % |
| Software costs as a % of software revenues |   | 6                                      | %      | 6                                    | %      | 6 | % | 4 | % |
| Services costs as a % of services revenues |   | 43                                     | %      | 51                                   | %      | 43 | % | 53 | % |

 

Costs of software consist primarily of product and software royaltiespaid to third parties for the use of their technologies in our products and, toa lesser extent, software packaging costs, which include product media,duplication and documentation. Costs of software can fluctuate depending onwhich software applications are licensed to our customers, and the third partytechnology, if any, which is licensed. The increase in the software costs forthe three and six months ended June 30, 2004 compared to the three and sixmonths ended June 30, 2003 was due to increased royalties for third partysoftware.

 

Costs of services consist primarily of compensation expenses fortechnical support, education and professional services personnel and othercosts associated with supporting our resellers and customers. The decrease incosts of services and costs of services as a percent of services revenues forthe three and six months ended June 30, 2004 compared to June 30,2003 was a result of our focus on cost control, which resulted in a decrease inheadcount in this area, as well as a reduction in our utilization of outsidesources to provide professional services for our customers.

 

##### ***Gross Profit***

##### *** ***

|                         |   | **Three  Months Ended  June 30,** |   | **Six Months  Ended  June 30,** |   |
|------------------------------|--------|----------------------------------------|--------|--------------------------------------|--------|
|                         |   |                                   |   |
|                         |   | **2004**                               |   | **2003**                             |   | **2004** |   | **2003** |   |
|                         |   |                                   |   | **($ in  thousands)**                |   |   |   |
| Gross profit                 |   | $                                      | 10,466 |                                 | $      | 8,528 |   | $ | 20,824 |   | $ | 19,434 |   |
| Change from prior year       |   | 23                                     | %      | (6                                   | )%     | 7 | % | 10 | % |
| Percentage of total revenues |   | 77                                     | %      | 70                                   | %      | 76 | % | 74 | % |
|                              |        |                                        |        |                                      |        |  |  |  |  |  |  |  |  |  |

 

Gross profit and gross profit as a percentage of total revenuesincreased for the three and six months ended June 30, 2004 compared toJune 30, 2003. For the three months ended June 30, 2004 compared toJune 30, 2003, this increase was the result of an increase in softwarerevenues resulting from more perpetual license agreements and a decrease incost of services due to a reduction in headcount and reduction in theutilization of outside services. For the six months ended June 30, 2004compared to June 30, 2003, the increase was related to an increase inservices revenues resulting from our growing customer base, and a decrease incost of services due to a reduction in headcount and reduction in theutilization of outside services.

 

14

----

 

##### ***OperatingExpenses***

 

## *Sales and Marketing*

|                            |   | **Three Months Ended  June 30,** |   | **Six Months Ended  June 30,** |   |
|---------------------------------|--------|---------------------------------------|--------|-------------------------------------|--------|
|                            |   |                                  |   |
|                            |   | **2004**                              |   | **2003**                            |   | **2004** |   | **2003** |   |
|                            |   |                                  |   | **($ in  thousands)**               |   |   |   |
| Sales and marketing expenses    |   | $                                     | 5,076  |                                | $      | 4,910 |   | $ | 10,104 |   | $ | 10,117 |   |
| Change from prior year          |   | 3                                     | %      | (5                                  | )%     | 0 | % | (6 | )% |
| Percentage of total revenues    |   | 37                                    | %      | 41                                  | %      | 37 | % | 38 | % |
| Percentage of software revenues |   | 70                                    | %      | 85                                  | %      | 71 | % | 70 | % |
|                                 |        |                                       |        |                                     |        |  |  |  |  |  |  |  |  |  |

 

Sales and marketing expenses are comprised primarily of compensationexpense and travel, entertainment and other related expenses, which haveremained fairly consistent in the periods presented above.  As described previously under FinancialHighlights, we expect sales and marketing expenses to increase during the thirdand fourth quarters of 2004 related to the additional costs for Vonexus, anewly formed subsidiary.

 

## *Research and Development*

## * *

|                              |   | **Three  Months Ended  June 30,** |   | **Six Months  Ended  June 30,** |   |
|-----------------------------------|--------|----------------------------------------|--------|--------------------------------------|--------|
|                              |   |                                   |   |
|                              |   | **2004**                               |   | **2003**                             |   | **2004** |   | **2003** |   |
|                              |   |                                   |   | **($ in  thousands)**                |   |   |   |
| Research and development expenses |   | $                                      | 3,258  |                                 | $      | 3,472 |   | $ | 6,536 |   | $ | 6,967 |   |
| Change from prior year            |   | (6                                     | )%     | (6                                   | )%     | (6 | )% | (8 | )% |
| Percentage of total revenues      |   | 24                                     | %      | 29                                   | %      | 24 | % | 26 | % |
|                                   |        |                                        |        |                                      |        |  |  |  |  |  |  |  |  |  |

 

Research and development expenses are comprised primarily ofcompensation expenses.  Research anddevelopment expenses decreased slightly for the three and six months endedJune 30, 2004 compared to June 30, 2003 due to a small decrease inheadcount and depreciation.

 

## *General and Administrative*

## * *

|                                |   | **Three  Months Ended  June 30,** |   | **Six Months  Ended  June 30,** |       |
|-------------------------------------|--------|----------------------------------------|--------|--------------------------------------|------------|
|                                |   |                                   |   |
|                                |   | **2004**                               |   | **2003**                             |       | **2004** |   | **2003** |   |
|                                |   |                                   |   | **($ in thousands)**                 | ** ** |   | ** ** |
| General and administrative expenses |   | $                                      | 1,722  |                                 | $          | 1,356 |   | $ | 3,593 |   | $ | 2,812 |   |
| Change from prior year              |   | 27                                     | %      | (2                                   | )%         | 28 | % | (2 | )% |
| Percentage of total revenues        |   | 13                                     | %      | 11                                   | %          | 13 | % | 11 | % |
|                                     |        |                                        |        |                                      |            |  |  |  |  |  |  |  |  |

 

General and administrative expenses are comprised of compensationexpense and non-allocable expenses including bad debt, legal and otherprofessional service fees. General and administrative expenses increased forthe three and six months ended June 30, 2004 compared to June 30,2003. This increase is the result of higher legal expenses, including thehiring of a general counsel in the third quarter of 2003 and an increase inoutside legal expenses due to increased efforts to resolve litigation and otherclaims against the Company. See Note 5 of Notes to Condensed ConsolidatedFinancial Statements.

 

## *Restructuring and Other Charges*

## * *

|                            |   | **Three  Months Ended  June 30,** |   | **Six Months  Ended  June 30,** |   |
|---------------------------------|--------|----------------------------------------|--------|--------------------------------------|--------|
|                            |   |                                   |   |
|                            |   | **2004**                               |   | **2003**                             |   | **2004** |   | **2003** |   |
|                            |   |                                   |   | **($ in thousands)**                 |   |   |   |
| Restructuring and other charges |   | $                                      | 85     |                                 | $      | 2,690 |   | $ | 101 |   | $ | 3,138 |   |
| Change from prior year          |   | 97                                     | %      | 294                                  | %      | 97 | % | 360 | % |
| Percentage of total revenues    |   | 1                                      | %      | 22                                   | %      | 0 | % | 12 | % |
|                                 |        |                                        |        |                                      |        |  |  |  |  |  |  |  |  |

 

Restructuring and other charges decreased significantly for the threeand six months ended June 30, 2004 compared to June 30, 2003. Duringthe three months ended June 30, 2003, we incurred $2.7 million in chargesrelated to the restructuring of our European operations and relocation of ourworldwide headquarters. In February 2003, we announced our plan todownsize and reorganize our resources in EMEA. The French office was mostaffected with most of the French employees terminated or relocated.

 

15

----

 

We recognized these expenses in accordance with FASB Statement No. 146,*Accountingfor Costs Associated with Exit or Disposal Activities* (SFAS 146).The restructuring and other expenses recognized in the three and six monthsended June 30, 2004 were legal fees incurred during the period related tothe EMEA reorganization. We expect to incur some additional expenses related tothe restructuring of international operations in 2004; however, at this time,we do not expect the amount to be significant. See Note 6 of Notes to CondensedConsolidated Financial Statements. Although we do not currently believe that wewill need to further reduce staff, the state of the economy and resultingtechnology spending by businesses, among other factors, could result in furtherreductions.

 

Additionally, we moved our worldwide headquarters to a new building inIndianapolis, Indiana effective April 1, 2003. Because we continued to owelease payments on the previous headquarters, we determined that those leasepayments, net of sublease income, qualified as exit costs in accordance withSFAS 146. We recognized a total of $1.6 million of restructuring and othercharges for the three months ended June 30, 2003 related to thisrelocation.

 

##### ***InterestIncome, Net***

##### *** ***

The majority of interest income, net is made up of interest earned frominvestments and interest-bearing cash accounts. Interest expense, which is notmaterial for any periods reported, is also included in interest income, net. Wehave experienced decreased interest earnings as shown below.

 
|                                                         |   | **Three  Months Ended  June 30,** |   | **Six Months  Ended  June 30,** |   |
|--------------------------------------------------------------|--------|----------------------------------------|--------|--------------------------------------|--------|
|                                                         |   |                                   |   |
|                                                         |   | **2004**                               |   | **2003**                             |   | **2004** |   | **2003** |   |
|                                                         |   |                                   |   | **($ in  thousands)**                |   |   |   |
| Cash, cash equivalents and short-term  investments (average) |   | $                                      | 15,065 |                                 | $      | 15,857 |   | $ | 15,238 |   | $ | 15,194 |   |
| Interest income                                              |   | 26                                     |   | 48                                   |   | 46 |   | 107 |   |
| Return on investment (annual)                                |   | 0.7                                    | %      | 1.2                                  | %      | 0.6 | % | 1.4 | % |
|                                                              |        |                                        |        |                                      |        |  |  |  |  |  |  |  |  |

 

The decrease in net interest income for the three and six months endedJune 30, 2004 compared to June 30, 2003 was related mainly to adecrease in interest rates, an increase in interest expense and to the mix ofinvestments. In 2003, we utilized short-term investments in our investingstrategy, while in 2004, all cash was held in cash and cash equivalentsaccounts. Cash and cash equivalents earn a lower rate of return than short-terminvestments. We opted to invest in this more liquid mix of investments in 2004in order to ensure the availability of our cash.

 

### **Liquidity and Capital Resources**

### ** **

In 1999 we raised cash through an initial public offering that providednet proceeds of $34.9 million. In 2001 we received an equity investment thatyielded $15 million in cash. In addition, we generate cash from the collectionswe receive related to licensing our application software and from annuallicense renewals, maintenance and support and other services revenues. We alsohave in place a $3 million line of credit, which was fully utilized as ofJune 30, 2004 and repaid in full subsequent to June 30, 2004. We use cashprimarily for paying our employees (including salaries, commissions, benefitsand severance), leasing office space, reimbursing travel expenses, payinginsurance premiums and paying vendors for services rendered and suppliespurchased. In addition, we purchase property and equipment, includingfurnishing our new worldwide headquarters and in-house technology purchases.

 

We determine liquidity by combining cash and cash equivalents andshort-term investments net of our line of credit borrowings as shown in thetable below. Our total liquidity position decreased as of June 30, 2004compared with our position as of December 31, 2003. In general thisdecrease was due to the timing

 

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of our accounts receivable collections. We believe that our currentliquidity position, when combined with our anticipated cash flows fromoperations, will be sufficient to satisfy our cash needs over the next 12months. If cash flows from operations are less than anticipated or we haveadditional 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 beforced to raise additional capital, either through the capital markets or debtfinancings. We may not be able to receive favorable terms in raising thiscapital.

 
|                      |   | **June 30,  2004** |   | **December 31,  2003** |   |
|---------------------------|--------|-------------------------|--------|-----------------------------|--------|
|                      |   |                    |   |
|                      |   | **($ in  thousands)**   |   |
| Cash and cash equivalents |   | $                       | 15,006 |                        | $      | 12,461 |   |
| Short-term investments    |   | —                  |   | 3,008                       |   |
| Line of credit            |   | (3,000                  | )      | (2,800                      | )      |
| Liquidity, net            |   | $                       | 12,006 |                        | $      | 12,669 |   |

 

Our operating activities resulted in a net cash outflow of $382,000 forthe six months ended June 30, 2004 compared with a net cash inflow of $2.0million for the six months ended June 30, 2003. These cash results fromour operating activities were affected by accounts receivable fluctuations (thebalance decreased $473,000 for the six months ended June 30, 2004 comparedto a decrease of $1.9 million for the six months ended June 30, 2003),accounts payable fluctuations (the balance remained consistent for the sixmonths ended June 30, 2004 compared to an increase of $1.4 million for thesix months ended June 30, 2003) and changes in deferred revenues (whichdecreased $2.8 million for the six months ended June 30, 2004 compared toa decrease of $1.3 million for the six months ended June 30, 2003).

 

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

 

We purchased property and equipment with a cost of $583,000 and $2.4million in the six months ended June 30, 2004 and 2003, respectively. Wemoved our worldwide headquarters in the second quarter of 2003.

 

The net increase in our borrowings on our line of credit provided cashof $200,000 for the six months ended June 30, 2004.

 

### **Critical Accounting Policies and Estimates**

### ** **

We believe there are three accounting policies that are important tounderstanding our historical and future performance, as these policies affectthe reported amounts of revenues and expenses and are the more significantareas involving management’s judgments and estimates. These critical accountingpolicies and estimates relate to revenue recognition, the allowance fordoubtful accounts receivable and research and development. These policies, andour procedures related to these policies, are described below.

 

##### ***Sources ofRevenues and Revenue Recognition Policy***

##### *** ***

We generate software revenues from licensing the right to use oursoftware applications and generate services revenues primarily from annualrenewal fees, annual maintenance fees, educational services and professionalservices. We believe both of these sources of revenues are critical to ourfinancial statements because of their materiality to our statements as a wholeand because of the judgment required in determining if revenue recognitioncriteria have been met.

 

## *Software Revenues*

## * *

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

 

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•                  persuasiveevidence of an arrangement exists;

•                  the fee is fixedor determinable;

•                  collection isprobable; and

•                  delivery hasoccurred.

 

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

 

For a perpetual software license agreement, upon meeting the revenuerecognition criteria above, we immediately recognize as software revenues theamount of initial license fees if sufficient vendor specific objective evidenceexists to support allocating a portion of the total fee to the undeliveredelements of the arrangement. If sufficient vendor specific objective evidenceof the fair value of the undelivered elements does not exist, we recognize theinitial license fee as software revenues ratably over the initial term of themaintenance agreement, which is generally 12 months.

 

## *Services Revenues*

## * *

Services revenues are recognized for annually renewable softwarelicense agreements and perpetual software license agreements. For annuallyrenewable software license agreements, the allocation of the initial orderbetween software revenues and services revenues is based on an average ofactual renewal fee rates. After the initial license period, our customers mayrenew their license agreement for an additional period, typically 12 months, bypaying a renewal fee. Under perpetual software license agreements, we recognizeinitial annual maintenance fees based on actual renewal fee rates as servicesrevenues ratably over the post-contract maintenance period, which is typically12 months beginning at the date support is deemed to commence.

 

We also generate services revenues from other services that we provideto our resellers and customers. These additional services revenues include feesfor educational services and professional services. Revenues from educationalservices, which consist of training courses for resellers and customers, andprofessional services, which include implementing and customizing our productsfor a customer, are typically recognized as the related services are performed.

 

##### ***Allowance forDoubtful Accounts Receivable***

##### *** ***

We adjust our allowance for doubtful accounts for each reporting periodbased on a detailed analysis of our accounts receivable at the end of thatperiod. In estimating the allowance for doubtful accounts, we primarilyconsider the age of the reseller’s or customer’s receivable and also considerthe creditworthiness of the reseller or customer, the economic conditions ofthe customer’s industry, and general economic conditions, among other factors.If payment is not made timely, we contact the customer or reseller to try toobtain payment. If this is not successful, we institute other collectionpractices such as generating collection letters, involving our salesrepresentatives, involving a third party collection agency and ultimatelyterminating the customer’s license(s) and/or the customer’s and reseller’saccess to future upgrades, licenses and customer support. Once all collectionefforts are exhausted, the receivable is written off against the allowance fordoubtful accounts.

 

##### ***Research andDevelopment***

##### *** ***

Research and development expenditures are generally expensed asincurred. Based on our product development process and technologicalfeasibility, the date at which capitalization of development costs may begin isestablished upon completion of a working model. Costs incurred betweencompletion of the working model and the point at which the product is ready forgeneral release have been insignificant. Through June 30, 2004, allresearch and development costs have been expensed.

 

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**Factors that may affect our future operatingresults are set forth below:**

 

**THE OVERALL ECONOMIC CLIMATE MAY BE WEAK**

 

Our products typically represent substantial capital commitments bycustomers and involve a potentially long sales cycle. As a result, customerpurchase decisions may be significantly affected by a variety of factors,including general economic trends in the allocation of capital spending budgetsto communication software, services and systems, lengthened sales cycles, customerapproval processes, and market conditions, which have resulted in many of ourcustomers delaying and/or reducing their capital spending related toinformation systems. If the economy is weak, demand for our products coulddecrease, resulting in lower revenues.

 

**WE HAVE HISTORICALLY INCURRED LOSSES AND WEMAY NOT SUSTAIN PROFITABILITY**

 

Since inception, the first quarter of 2003 and the first two quartersof 2004 were the only quarters we have been profitable. We incurred net incomeof $424,000 in the six months ended June 30, 2004 and net losses of $5.9million, $7.7 million and $11.0 million for the years endedDecember 31, 2003, 2002 and 2001, respectively. At June 30, 2004, wehad accumulated net losses since inception of $60.9 million. We intend tocontinue to make significant investments in our research and development,marketing, services and sales operations. Certain of these expenses willprecede generation of revenues. As a result, we may continue to experiencelosses and/or negative cash flow from operations in future quarters.

 

**OUR QUARTERLY OPERATING RESULTS HAVE VARIEDSIGNIFICANTLY**

 

Our operating results have varied significantly from quarter to quarterand may continue to do so in the future depending on a number of factorsaffecting us or our industry, including many that are beyond our control. As aresult, we believe that period-to-period comparisons of our operating resultsare not necessarily meaningful, and you should not rely on them as anindication of our future performance. In addition, our operating results in afuture quarter or quarters may fall below expectations of securities analystsor investors and, as a result, the price of our common stock may fluctuate.

 

Because we do not know if or when our potential customers will placeorders and finalize licenses, and because it is difficult to predict the mix ofannually renewable licenses and perpetual licenses in a quarter, we cannotaccurately forecast our licensing activity, our revenues and our operatingresults for future quarters. We recognize revenues from different licenses overdifferent periods depending on the satisfaction of the requirements of relevantaccounting literature, including AICPA Statement of Position 97-2, Statement ofPosition 98-9, SEC Staff Accounting Bulletin (SAB) 101, and all related AICPATechnical Practice Aids (5100.38 - 5100.76). As a result, ourquarterly revenues and operating results depend on many factors, including thetype of license, the size, quantity and timing of orders received for our productsduring each quarter, the delivery of the related software and our expectationsregarding collection. If a large number of orders or several large orders donot occur or are deferred or delayed, our revenues in a quarter could besubstantially reduced. This risk is heightened by the significant investmentand executive level decision-making typically involved in our customers’decisions to license our products. Since a large portion of our operatingexpenses, including salaries and rent, is fixed and difficult to reduce ormodify in a short time period, our business, financial condition or results ofoperations could be materially adversely affected if revenues do not meet ourexpectations.

 

Our limited number of products, changes in pricing policies, the timingof development completion, and announcement and sale of new or upgradedversions of our products are some of the additional factors that could causeour revenues and operating results to vary significantly from quarter toquarter.

 

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**WE HAVE A LENGTHY PRODUCT SALES CYCLE WHICHHAS CONTRIBUTED AND MAY CONTINUE TO CONTRIBUTE TO THE VARIABILITY OF QUARTERLYOPERATING RESULTS**

 

We have generally experienced a lengthy product sales cycle, averagingapproximately six to nine months. The lengthy sales cycle is one of the factorsthat has caused, and may in the future continue to cause, our software revenuesand operating results to vary significantly from quarter to quarter, whichcould affect the market price of our common stock. The lengthy sales cycle alsomakes it difficult for us to forecast product license revenues. Because of theunique characteristics of our products, our prospective customers’ decisions tolicense our products often require significant investment and executive-leveldecision making. We believe that many companies currently are not aware of thebenefits of interaction management software of the type that we license or ofour products and capabilities. For this reason, we must provide a significantlevel of education to prospective customers about the use and benefits of ourproducts, which can cause potential customers to take many months to make thesedecisions. As a result, sales cycles for customer orders vary substantiallyfrom customer to customer. Excessive delay in product sales could materiallyadversely affect our business, financial condition or results of operations.

 

The length of the sales cycle for customer orders depends on a numberof other factors over which we have little or no control, including:

 

•                  a customer’sbudgetary constraints;

•                  the timing of acustomer’s budget cycles;

•                  concerns bycustomers about the introduction of new products by us or our competitors; and

•                  downturns ingeneral economic conditions, including reductions in demand for contact centerservices.

 

The sales cycle for our products in international markets has been, andis expected to continue to be, longer than the sales cycle in the UnitedStates. The average sales cycle for our products may lengthen as we continue toexpand internationally.

 

**OUR INABILITY TO SUCCESSFULLY MANAGE OURINCREASINGLY COMPLEX THIRD PARTY RELATIONSHIPS COULD ADVERSELY AFFECT US**

 

As the complexity of our product technology and our reseller and otherthird party relationships have increased, the management of those relationshipsand the negotiation of contractual terms sufficient to protect our rights andlimit our potential liabilities have become more complicated, and we expectthis trend to continue in the future. As a result, our inability tosuccessfully manage these relationships or negotiate sufficient contractualterms could have a material adverse effect on us.

 

**WE FACE COMPETITIVE PRESSURES, WHICH MAY HAVEA MATERIAL ADVERSE EFFECT ON US**

 

The market for our software applications is highly competitive and,because there are relatively low barriers to entry in the software market, weexpect competition to increase in the future. In addition, because our industryis evolving and characterized by rapid technological change, it is difficultfor us to predict whether, when and by whom new competing technologies or newcompetitors may be introduced into our markets. Currently, our competitioncomes from several different market segments, including computer telephony platformdevelopers, computer telephony applications software developers andtelecommunications equipment vendors. We cannot assure you that we will be ableto compete effectively against current and future competitors. In addition,increased competition or other competitive pressures may result in pricereductions, reduced margins or loss of market share, any of which could have amaterial adverse effect on our business, financial condition or results ofoperations.

 

Many of our current and potential competitors have longer operatinghistories, significantly greater financial, technical, marketing, customerservice and other resources, greater name recognition and a larger

 

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installed base of customers than we do. As a result, these competitorsmay be able to respond to new or emerging technologies and changes in customerrequirements faster and more effectively than we can, or to devote greaterresources to the development, promotion and sale of products than we can.Current and potential competitors have established, and may in the futureestablish, cooperative relationships among themselves or with third parties,including mergers or acquisitions, to increase the ability of their products toaddress the needs of our current or prospective customers. If these competitorswere to acquire significant market share, it could have a material adverseeffect on our business, financial condition or results of operations.

 

**WE MAY NOT BE ABLE TO GROW OUR BUSINESS IF WEDO NOT MAINTAIN SUCCESSFUL RELATIONSHIPS WITH OUR RESELLERS AND OEM PARTNERSAND CONTINUE TO RECRUIT AND DEVELOP ADDITIONAL SUCCESSFUL RESELLERS AND OEMPARTNERS**

 

Our ability to achieve revenue growth in the future will depend in parton our success in maintaining successful relationships with our existing andfuture resellers and OEM partners and in recruiting and training additionalresellers and OEM partners. We rely primarily on resellers to market andsupport our products and plan on continuing to rely heavily on such partners inthe future. We are still developing our reseller and OEM distribution networksand may be unable to attract additional resellers with both voice and dataexpertise or appropriate OEM partners that will be able to market our productseffectively and that will be qualified to provide timely and cost-effectivecustomer support and service. We generally do not have long-term or exclusiveagreements with our resellers or OEM partners, and the loss of specific largerresellers or OEM partners or a significant number of resellers or OEM partnerscould materially adversely affect our business, financial condition or resultsof operations.

 

**OUR MARKETS ARE CHARACTERIZED BY RAPIDTECHNOLOGICAL CHANGE WHICH MAY CAUSE US TO INCUR SIGNIFICANT DEVELOPMENT COSTSAND PREVENT US FROM ATTRACTING NEW CUSTOMERS**

 

The market for our products is characterized by rapid technologicalchange, frequent new product introductions and enhancements, uncertain productlife cycles and changing customer demands. The introduction of productsembodying new technologies and the emergence of new industry standards couldrender existing products obsolete or unmarketable and cause us to incursignificant development costs and prevent us from attracting new customers.

 

**A DECLINE IN MARKET ACCEPTANCE FOR MICROSOFTTECHNOLOGIES ON WHICH OUR PRODUCTS RELY COULD HAVE A MATERIAL ADVERSE EFFECT ONUS**

 

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

 

**OUR FUTURE BUSINESS PROSPECTS DEPEND IN PARTON OUR ABILITY TO MAINTAIN AND IMPROVE OUR CURRENT PRODUCTS AND DEVELOP NEWPRODUCTS**

 

We believe that our future business prospects depend in large part onour ability to maintain and improve our current software applications and todevelop new software applications on a timely basis. Our software applicationswill have to continue to achieve market acceptance, maintain technologicalcompetitiveness and meet an expanding range of customer requirements. As aresult of the complexities

 

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inherent in our applications, major new applications and applicationenhancements require long development and testing periods. We may not besuccessful in developing and marketing, on a timely and cost effective basis,application enhancements or new software applications that respond totechnological change, evolving industry standards or customer requirements. Wemay also experience difficulties that could delay or prevent the successfuldevelopment, introduction or marketing of application enhancements, and our newapplications and application enhancements may not achieve market acceptance.Significant delays in the general availability of new releases of our softwareapplications or significant problems in the installation or implementation ofnew releases of our applications could have a material adverse effect on ourbusiness, financial condition or results of operations.

 

**SLOW GROWTH, OR A DECLINE IN DEMAND FORINTERACTION MANAGEMENT SOFTWARE OF THE TYPE WE LICENSE, COULD MATERIALLYADVERSELY AFFECT OUR FINANCIAL RESULTS AND GROWTH PROSPECTS**

 

If the demand for interaction management software of the type welicense does not grow within each of our four targeted markets, our financialresults and ability to grow our business could be materially adverselyaffected. All of our revenues have been generated from licenses of ourInteraction Center Platform software or complementary products, and relatedsupport, educational and professional services. We expect these products and servicesto account for the majority of our revenues for the foreseeable future.Although we believe demand for the functions performed by our products is high,the market for our products and services is still emerging. Further, our growthplans require us to successfully attract enterprise and service providercustomers in significantly larger numbers than we have historically achieved.

 

**IF OUR CUSTOMERS DO NOT PERCEIVE OUR PRODUCTSOR THE RELATED SERVICES PROVIDED BY US OR OUR RESELLERS OR OEM PARTNERS TO BEEFFECTIVE OR OF HIGH QUALITY, OUR BRAND AND NAME RECOGNITION WILL SUFFER**

 

We believe that establishing and maintaining brand and name recognitionis critical for attracting, retaining and expanding customers in our targetmarkets. We also believe that the importance of reputation and name recognitionwill increase as competition in our market increases. Promotion and enhancementof our name will depend on the effectiveness of our marketing and advertisingefforts and on our success in providing high-quality products and relatedservices, neither of which can be assured. If our customers do not perceive ourproducts or related services to be effective or of high quality, our brand andname recognition would suffer which could have a material adverse effect on ourbusiness, financial condition or results of operations.

 

**WE MAY NOT BE ABLE TO PROTECT OUR PROPRIETARYRIGHTS ADEQUATELY, WHICH COULD ALLOW THIRD PARTIES TO COPY OR OTHERWISE OBTAINAND USE OUR TECHNOLOGY WITHOUT AUTHORIZATION**

 

We regard our software products as proprietary. In an effort to protectour proprietary rights, we rely primarily on a combination of copyright,trademark and trade secret laws, as well as patents, licensing and otheragreements with consultants, suppliers, strategic and OEM partners, resellersand customers, and employee and third-party non-disclosure agreements. Theselaws and agreements provide only limited protection of our proprietary rights.It may be possible for a third party to copy or otherwise obtain and use our technologywithout authorization. A third party could also develop similar technologyindependently. In addition, the laws of some countries in which we sell ourproducts do not protect our software and intellectual property rights to thesame extent as the laws of the United States. Unauthorized copying, use orreverse engineering of our products could materially adversely affect ourbusiness, results of operations or financial condition.

 

We license technology that is embedded in our products. If one or moreof these licenses terminates or cannot be renewed on satisfactory terms, wewould have to modify the affected products to use alternative

 

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technology or eliminate the affected product function, either of whichcould have a material adverse effect on us.

 

**INFRINGEMENT CLAIMS COULD ADVERSELY AFFECT US**

 

Third parties have claimed or may in the future claim that ourtechnology infringes their proprietary rights. As the number of softwareproducts in our target markets increases and the functionality of theseproducts overlap, we believe that software developers may face additionalinfringement claims. See Note 5 of Notes to the Condensed ConsolidatedFinancial Statements for a description of contingencies.

 

Infringement claims, even if without merit, can be time consuming andexpensive to defend. A third party asserting infringement claims against us orour customers with respect to our current or future products may require us toenter into costly royalty arrangements or litigation, or otherwise materiallyadversely affect us.

 

**WE DEPEND ON KEY PERSONNEL AND WILL NEED TORETAIN AND RECRUIT SKILLED PERSONNEL, FOR WHICH COMPETITION IS INTENSE, TOCONDUCT AND GROW OUR BUSINESS EFFECTIVELY**

 

Our success depends in large part on the continued service of our keypersonnel, particularly Dr. Donald E. Brown, our Chief Executive Officerand principal stockholder. The loss of the services of Dr. Donald E. Brownor other key personnel could have a material adverse effect on our business,financial condition or results of operations. Our future success also dependson our ability to attract, train, assimilate and retain additional qualifiedpersonnel. Competition for persons with skills in the software industry isintense, particularly for those with relevant technical and/or salesexperience. We cannot assure you that we will be able to retain our keyemployees or that we can attract, train, assimilate or retain other highlyqualified personnel in the future.

 

**WE MAY PURSUE ACQUISITIONS THAT BY THEIRNATURE PRESENT RISKS AND THAT MAY NOT BE SUCCESSFUL**

 

In the future we may pursue acquisitions to diversify our productofferings and customer base or for other strategic purposes. We have no priorhistory of making material acquisitions and we cannot assure you that anyfuture acquisitions will be successful. The following are some of the risksassociated with acquisitions that could have a material adverse effect on ourbusiness, financial condition or results of operations:

 

•                  We cannot assurethat any acquired businesses will achieve anticipated revenues, earnings orcash flow.

•                  Wemay be unable to integrate acquired businesses successfully and realizeanticipated economic, operational and other benefits in a timely manner, particularlyif we acquire a business in a market in which we have limited or no currentexpertise, or with a corporate culture different from our own. If we are unableto integrate acquired businesses successfully, we could incur substantial costsand delays or other operational, technical or financial problems.

•                  Acquisitionscould disrupt our ongoing business, distract management, divert resources andmake it difficult to maintain our current business standards, controls andprocedures.

•                  We may financefuture acquisitions by issuing common stock for some or all of the purchaseprice. This could dilute the ownership interests of our stockholders. We mayalso incur additional debt or be required to recognize expense related tointangible assets recorded in future acquisitions.

•                  We may becompeting with other firms, many of which have greater financial and otherresources, to acquire attractive companies, making it more difficult to acquiresuitable companies on acceptable terms.

 

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**OUR INTERNATIONAL OPERATIONS INVOLVEFINANCIAL AND OPERATIONAL RISKS**

 

Our international operations require significant management attentionand financial resources to establish and operate, including hiring appropriatepersonnel and recruiting effective international resellers. Non-North Americanrevenues accounted for 20%, 13%, 19% and 22% of our total revenues for the sixmonths ended June 30, 2004 and the years ended December 31, 2003,2002, and 2001, respectively. We have marketing efforts in the Americas, EMEAand APAC. To date, our products have been licensed outside North Americaprimarily in Western Europe, South Africa, and Australia. We intend to continueto emphasize our international operations and we may enter additional internationalmarkets. Revenues from international operations may be inadequate to cover theexpenses of those operations. In addition to foreign currency fluctuationrisks, other risks inherent in our international business activities mayinclude the following:

 

•                  economic andpolitical instability;

•                  unexpectedchanges in foreign regulatory requirements and laws;

•                  tariffs andother trade barriers;

•                  timing, cost andpotential difficulty of adapting our software products to the local language inthose foreign countries that do not use the alphabet that English uses, such asJapan, Korea and China;

•                  lack ofacceptance of our products in foreign countries;

•                  longer salescycles and accounts receivable payment cycles;

•                  potentiallyadverse tax consequences;

•                  restrictions onthe repatriation of funds;

•                  acts ofterrorism; and

•                  increasedgovernment regulations related to increasing or reducing business activity invarious countries.

 

**FLUCTUATIONS IN THE VALUE OF FOREIGNCURRENCIES COULD RESULT IN LOSSES**

 

Our international revenues are generally denominated in U.S. dollarswith the exception of some European resellers and customers located incountries who have adopted the Euro as their official currency. Ourinternational expenses are generally denominated in local foreign currencies.Although foreign currency translation gains and losses have been immaterial todate, fluctuations in exchange rates between the U.S. dollar and othercurrencies could have a material adverse effect on our business, financial conditionor results of operations, and particularly on our operating margins. To date,we have minimally sought to hedge the risks associated with fluctuations inexchange rates, but we may more actively undertake to do so in the future. Anyhedging techniques we implement in the future may not be successful. Exchangerate fluctuations could also make our products more expensive than competitiveproducts not subject to these fluctuations, which could adversely affect ourrevenues and profitability in international markets.

 

**OUR PRODUCTS COULD HAVE DEFECTS FOR WHICH WEARE POTENTIALLY LIABLE AND WHICH COULD RESULT IN LOSS OF REVENUE, INCREASEDCOSTS OR LOSS OF OUR CREDIBILITY OR DELAY IN ACCEPTANCE OF OUR PRODUCTS IN THEMARKET**

 

Our products, including components supplied by others, may containerrors or defects, especially when first introduced or when new versions arereleased. Despite internal product testing, we have in the past discoveredsoftware errors in some of our products after their introduction. Errors in newproducts or releases could be found after commencement of commercial shipments,and this could result in additional development costs, diversion of technicaland other resources from our other development efforts, or the loss ofcredibility with current or future customers. This could result in a loss ofrevenue or delay in market acceptance of our products, which could have amaterial adverse effect on our business, financial condition or results ofoperations.

 

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

 

Performance interruptions in our products could also affect demand forour products or give rise to claims against us.

 

**WE MAY NOT BE ABLE TO OBTAIN ADEQUATEFINANCING TO IMPLEMENT OUR STRATEGY**

 

Successful implementation of our strategy may require continued accessto capital. If we do not generate sufficient cash from operations, our growthcould be limited unless we are able to obtain capital through additional debtor equity financings. We cannot assure you that debt or equity financings willbe available as required for acquisitions or other needs. Even if financing isavailable, it may not be on terms that are favorable to us or sufficient forour needs. If we are unable to obtain sufficient financing, we may be unable tofully implement our growth strategy.

 

**OUR STOCK PRICE HAS BEEN AND COULD CONTINUETO BE HIGHLY VOLATILE**

 

Our stock price has been and could continue to be highly volatile dueto a number of factors, including:

 

•                  actual oranticipated fluctuations in our operating results;

•                  announcements byus, our competitors or our customers;

•                  changes infinancial estimates of securities analysts or investors regarding us, ourindustry or our competitors;

•                  technologicalinnovations by others;

•                  the operatingand stock price performance of other comparable companies or of ourcompetitors;

•                  the low numberof our shares typically traded in any trading session;

•                  the availabilityfor future sale, or sales, of a substantial number of shares of our commonstock in the public market; and

•                  general marketor economic conditions.

 

This risk may be heightened because our industry is new and evolving,characterized by rapid technological change and susceptible to the introductionof new competing technologies or competitors.

 

In addition, the stock market has experienced significant price andvolume fluctuations that have particularly affected the trading prices ofequity securities of many technology companies, including us. These price andvolume fluctuations often have been unrelated to the operating performance ofthe affected companies. In the past, following periods of volatility in themarket price of a company’s securities, securities class action litigation hasoften been instituted against that company. This type of litigation, regardlessof the outcome, could result in substantial costs and a diversion ofmanagement’s attention and resources, which could materially and adverselyaffect our business, financial condition or results of operations.

 

**OUR COMMON STOCK IS SUBJECT TO VARIOUSLISTING REQUIREMENTS**

 

The various markets operated by The NASDAQ Stock Market havequantitative maintenance criteria for continued listing of common stock. We maybe delisted from one or more NASDAQ markets if we fail to comply with thecriteria. While we believe that we currently meet criteria for listing on amarket operated by The NASDAQ Stock Market, we can offer no assurance that ourcommon stock will continue to meet the various criteria for continued listingon any market operated by The NASDAQ Stock Market.

 

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Any delisting may result in a reduction in the liquidity of our commonstock, which may have a material adverse effect on the price of our commonstock.

 

**REGULATORY CHANGES MADE TO ACCOUNTINGPRINCIPLES GENERALLY ACCEPTED IN THE UNITED STATES OF AMERICA OR CORPORATEGOVERNANCE MATTERS MAY IMPACT OUR BUSINESS**

 

Revisions to accounting principles generally accepted in the UnitedStates of America will require us to review our accounting and financialreporting procedures in order to ensure continued compliance with requiredpolicies. From time to time, such changes may have a short-term impact on ourreporting, and these changes may impact market perception of our financialcondition. In addition, legislative changes, and the perception these changescreate, can have a material, adverse effect on our business. For example:

 

•                  pending or newlegislation may lead to an increase in our costs related to audits inparticular and regulatory compliance generally; and

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

 

**OUR EXECUTIVE OFFICERS AND DIRECTORS CONTROLUS AND MAY MAKE DECISIONS THAT SHAREHOLDERS DO NOT CONSIDER TO BE IN THEIR BESTINTERESTS**

 

Our current directors and executive officers together beneficially ownmore than 50% of our outstanding common stock. Accordingly, these shareholdersare able to control us through their ability to determine the outcome of theelection of our directors, amend our Restated Articles of Incorporation andBy-Laws and take other actions requiring the vote or consent of shareholders,including mergers, going private transactions and other extraordinarytransactions, and the terms of any of these transactions. The ownershipposition of these shareholders may have the effect of delaying, deterring orpreventing a change in control or a change in the composition of our board ofdirectors.

 

**ANTI-TAKEOVER PROVISIONS IN OURORGANIZATIONAL DOCUMENTS AND INDIANA LAW MAKE ANY CHANGE IN CONTROL OF US MOREDIFFICULT, MAY DISCOURAGE BIDS AT A PREMIUM OVER THE MARKET PRICE AND MAYADVERSELY AFFECT THE MARKET PRICE OF OUR STOCK**

 

Our Restated Articles of Incorporation and By-Laws contain provisionsthat may have the effect of delaying, deferring or preventing a change incontrol of us, may discourage bids at a premium over the market price of ourcommon stock and may adversely affect the market price of our common stock, andthe voting and other rights of the holders of our common stock. Theseprovisions include:

 

•                  the division ofour board of directors into three classes serving staggered three-year terms;

•                  removal ofdirectors only for cause and only upon a 66 2/3% shareholder vote;

•                  prohibitingshareholders from calling a special meeting of shareholders;

•                  the ability toissue additional shares of our common stock or preferred stock withoutshareholders’ approval; and

•                  advance noticerequirements for raising business or making nominations at shareholders’ meetings.

 

The Indiana corporation law contains business combination provisionsthat, in general, prohibit for five years any business combination with abeneficial owner of 10% or more of our common stock unless the holder’sacquisition of the stock was approved in advance by our board of directors. TheIndiana corporation law also contains control share acquisition provisions thatlimit the ability of certain shareholders to vote their shares unless theircontrol share acquisition was approved in advance.

 

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**WE CANNOT PREDICT EVERY EVENT ANDCIRCUMSTANCE THAT MAY IMPACT OUR BUSINESS AND, THEREFORE, THE RISKS ANDUNCERTAINTIES DISCUSSED ABOVE MAY NOT BE THE ONLY ONES YOU SHOULD CONSIDER**

 

The risks and uncertainties discussed above are in addition to thosethat apply to most businesses generally. In addition, as we continue to growour business, we may encounter other risks of which we are not aware at thistime. These additional risks may cause serious damage to our business in thefuture, the impact of which we cannot estimate at this time.

 

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

 

We develop products in the United States and sell licenses in theAmericas, EMEA and APAC. As a result, our financial results could be affectedby various factors, including changes in foreign currency exchange rates orweak economic conditions in foreign markets. As most sales are currently madein U.S. dollars, a strengthening of the dollar could make our products lesscompetitive in foreign markets. Additionally, as our business matures inforeign markets, we may offer our products and services in certain other localcurrencies. As a result, we will be subject to foreign currency fluctuationswhich may have an adverse affect on our company.

 

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

 

**Item 4****. Controlsand Procedures**

 

We maintain a set of disclosure controls and procedures that aredesigned to ensure that information required to be disclosed by us in thereports filed by us under the Securities Exchange Act of 1934, as amended(Exchange Act) is recorded, processed, summarized and reported within the timeperiods specified in the SEC’s rules and forms. We carried out an evaluation,under the supervision and with the participation of our management, includingour President and Chief Executive Officer and our Chief Financial Officer andTreasurer, of the effectiveness of the design and operation of our disclosurecontrols and procedures as of June 30, 2004 pursuant to Rule 13a-15(b) ofthe Exchange Act. Based on that evaluation, our President and Chief ExecutiveOfficer and our Chief Financial Officer and Treasurer concluded that ourdisclosure controls and procedures are effective.

 

There have been no changes in our internal control over financialreporting that occurred during the quarter ended June 30, 2004 that havematerially affected, or are reasonably likely to materially affect, ourinternal control over financial reporting.

 

**P**ARTII. OTHER INFORMATION

** **

**Item 1. Legal Proceedings****.**

 

From time to time we have received claims from competitors and othertechnology providers claiming that our technology infringes their respectiveproprietary rights. One such claim has resulted in a legal proceeding beingfiled against us, which is described below. In addition, we are involved incertain legal proceedings in the ordinary course of conducting our business. Webelieve these claims and legal proceedings can be resolved without a materialadverse effect on our business, financial condition or results from operations;however, we cannot provide assurance as to the outcome. Litigation in general,and intellectual property litigation in particular, can be expensive anddisruptive to normal business operations. Moreover, the results of complexlegal proceedings are difficult to predict.

 

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In 2002, we received a letter from a consulting firm that has beenretained by a telecommunication technology provider to develop and implement alicensing program based on the technology provider’s patents. The consultingfirm believes that we have infringed on the technology provider’s proprietyrights and therefore feels that a licensing agreement between us and thetechnology provider is appropriate. We believe that we did not infringe on thetechnology provider’s proprietary rights; however, because of the cost ofdefending such a matter in court, we did offer a settlement. The technologyprovider has not accepted our offer of settlement. We do not believe asettlement is probable and the term over which a settlement would be recognizedis uncertain. We may be required to defend our position in a court of lawshould a lawsuit be filed. Because of the facts presented above, we have notrecorded an accrual for any settlement in this matter. We cannot provideassurance as to the outcome.

 

In 2002, we received a letter from one of our resellers requestingindemnification related to a request that the reseller had received forindemnification from a customer. The customer had received a letter from athird party indicating that the customer may be infringing patents held by thethird party. To date, our patent counsel has not determined the validity or theapplicability of these patents as they relate to our products or whether thereseller is entitled to indemnification. We believe that this matter can beresolved without a material adverse effect on our business, financial conditionor results of operations; however, we cannot provide assurance as to theoutcome.

 

On September 30, 2003, Recursion Software, Inc. filed suit inDallas County Court in Dallas, Texas against us alleging breach of contract andmoney due under claims of quantum meruit, unjust enrichment and infringement.Recursion claims that we incorporated Recursion software into one of ourproducts in breach of the underlying license. No dollar amount has been statedin the action. We believe that we have strong defenses to the claims and intendto vigorously defend against the action. We believe that this matter can beresolved without a material adverse effect on our business, financial conditionor results of operations; however, we cannot provide assurance as to theoutcome.

 

In 2002, we received a notification from the French government as aresult of a tax audit that had been conducted encompassing the years 1998,1999, 2000 and 2001. These assessments claim various taxes are owed related toValue Added Tax (VAT) and corporation taxes in addition to what has previouslybeen paid and accrued. As of June 30, 2004, the assessment related to VATwas approximately $2.8 million and the assessment related to corporation taxeswas approximately $366,000. Our tax counsel has assessed the possibility of uspaying the assessment related to VAT as remote and the assessment related tocorporation taxes as reasonably possible; we have not accrued for theseamounts. We are appealing the assessments, but cannot assure you that thesematters will be resolved without litigation or that we will not have to paysome or all of the assessments.

 

**Item 4. Submission of Matters to a Vote ofSecurity Holders****.**

 

We held our annual meeting of shareholders on May 19, 2004. At thatmeeting, our shareholders elected Mark E. Hill and reelected William E.McWhirter as Directors of the Company to each serve a three-year term and untilhis successor is elected and has qualified. Also at the meeting, ourshareholders approved an Amendment to our Outside Directors Stock Option Plan.The final results of the votes taken at the meeting were as follows:

 
|                                             |   | **Votes****For** |   | **Votes****Withheld** |   | **Broker****Non-Votes** |   | **Abstentions** |   |
|--------------------------------------------------|--------|------------------|--------|-----------------------|--------|-------------------------|--------|-----------------|--------|
|                                             |   |             |   |                  |   |
| Election of Directors:                           |   |             |   |                  |   |                    |   |            |   |
| Mark E. Hill                                     |   | 14,710,734       |   | 330,123               |   | —                  |   | —          |   |
| William E. McWhirter                             |   | 14,706,954       |   | 333,903               |   | —                  |   | —          |   |
|                                             |   |             |   |                  |   |                    |   |            |   |
| Amendment to Outside Directors Stock Option Plan |   | 11,000,645       |   | 572,115               |   | 3,444,533               |   | 23,564          |   |

 

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Inaddition, the following directors continue in office until the annual meetingof shareholders in the year indicated:

 
| Donald  E. Brown, M.D.    |   | 2005 |   |
|---------------------------|--------|------|--------|
| Robert  A. Compton        |   | 2005 |   |
| Samuel  F. Hulbert, Ph.D. |   | 2006 |   |

 

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

 

(a)          Exhibits

 

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

 

31.2  Certification of the Chief Financial Officerpursuant to Rule 13a-14(a)/15d-14(a) of the Securities Exchange Act of 1934, asadopted 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 theSarbanes-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-OxleyAct of 2002

 

(b)         Reports on Form 8-K

 

1. On July 27, 2004,the Company furnished, not filed, a Form 8-K attaching a press releasedescribing its results of operations for the quarter ended June 30, 2004.

 

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**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 theundersigned thereunto duly authorized.

 
|                      |   | Interactive Intelligence, Inc.  (Registrant)                                                                                                                                       |   |
|---------------------------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|
|                      |   |                                                                                                                                                                               |
|                      |   |                                                                                                                                                                               |   |
| Date: August 6, 2004 | By     | /s/ Stephen R. Head                                                                                                                                                                |   |
|                      |   |                                                                                                                                                                               |   |
|                      |   | Stephen R. Head*Chief  Financial Officer, Vice President of Finance and  Administration, Secretary and Treasurer  (Principal Financial Officer and Principal Accounting  Officer)* |   |
|                      |   |                                                                                                                                                                               |
|                      |   |                                                                                                                                                                               |
|                      |   |                                                                                                                                                                               |
|                      |   |                                                                                                                                                                               |

 

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