**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

 

**Washington,D.C. 20549**

 

----

 

**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 March 31, 2004** |
|                                                   |
| **Or**                                                 |
|                                                   |
| **o**                                                  | **TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF  THE SECURITIES EXCHANGE ACT OF 1934** |

 

**Forthe 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   No o

 

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

 

Yes o   No ý

 

The number of shares of common stock outstanding on April 30, 2004was 15,836,663.

 

 

----

 

TABLE OF CONTENTS

 
| PART I. FINANCIAL INFORMATION |
|-------------------------------|
|                          |   |
| Item 1.                       | Condensed Consolidated Balance Sheets as of  March 31, 2004 (unaudited) and December 31, 2003 |
|                          |   |
|                          | Condensed  Consolidated Statements of Operations for the three months ended  March 31, 2004 and 2003 (unaudited) |
|                          |   |
|                          | Condensed  Consolidated Statement of Shareholders’ Equity for the three months ended  March 31, 2004 (unaudited) |
|                          |   |
|                          | Condensed  Consolidated Statements of Cash Flows for the three months ended  March 31, 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 6.                       | Exhibits and Reports on Form 8-K |
|                          |   |
| SIGNATURES                    |

 

2

----

 

**PART I. FINANCIAL INFORMATION**

 

**Item 1. Condensed Consolidated FinancialStatements and Footnotes.**

 

**Interactive Intelligence, Inc.**

 

**CondensedConsolidated Balance Sheets**

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

 
|                                                                                                                                                                            |   | **March 31,  2004** |   | **December 31,  2003** |   |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|--------------------------|--------|-----------------------------|--------|
|                                                                                                                                                                            |   | **(unaudited)**          |   |                        |   |
| **Assets**                                                                                                                                                                      |   |                     |   |                        |   |
| Current assets:                                                                                                                                                                 |   |                     |   |                        |   |
| Cash and cash equivalents                                                                                                                                                       |   | $                        | 15,123 |                        | $      | 12,461 |   |
| Short-term investments                                                                                                                                                          |   | —                   |   | 3,008                       |   |
| Account receivable, net of allowance for  doubtful accounts of $404  in 2004 and $354 in 2003                                                                                   |   | 7,346                    |   | 8,956                       |   |
| Prepaid expenses                                                                                                                                                                |   | 2,260                    |   | 1,958                       |   |
| Other current assets                                                                                                                                                            |   | 527                      |   | 418                         |   |
| Total current assets                                                                                                                                                            |   | 25,256                   |   | 26,801                      |   |
| Property and equipment, net                                                                                                                                                     |   | 5,348                    |   | 5,857                       |   |
| Other assets, net                                                                                                                                                               |   | 641                      |   | 601                         |   |
| Total assets                                                                                                                                                                    |   | $                        | 31,245 |                        | $      | 33,259 |   |
|                                                                                                                                                                            |   |                     |   |                        |   |
| **Liabilities and  Shareholders’ Equity**                                                                                                                                  |   |                     |   |                        |   |
| Current liabilities:                                                                                                                                                            |   |                     |   |                        |   |
| Line of credit                                                                                                                                                                  |   | $                        | 1,200  |                        | $      | 2,800 |   |
| Accounts payable and accrued liabilities                                                                                                                                        |   | 4,532                    |   | 4,544                       |   |
| Accrued compensation and related expenses                                                                                                                                       |   | 1,426                    |   | 1,349                       |   |
| Deferred software revenues                                                                                                                                                      |   | 8,250                    |   | 8,745                       |   |
| Deferred services revenues                                                                                                                                                      |   | 11,879                   |   | 12,030                      |   |
| Total current liabilities                                                                                                                                                       |   | 27,287                   |   | 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;  15,816,666 issued and outstanding at March 31, 2004,  15,755,477 issued and outstanding at December 31, 2003 |   | 158                      |   | 157                         |   |
| Additional paid-in capital                                                                                                                                                      |   | 64,854                   |   | 64,696                      |   |
| Accumulated other comprehensive income                                                                                                                                          |   | 168                      |   | 280                         |   |
| Accumulated deficit                                                                                                                                                             |   | (61,222                  | )      | (61,342                     | )      |
| Total shareholders’ equity                                                                                                                                                 |   | 3,958                    |   | 3,791                       |   |
| Total liabilities and shareholders’ equity                                                                                                                                 |   | $                        | 31,245 |                        | $      | 33,259 |   |

 

See Notes to Condensed Consolidated FinancialStatements

 

3

----

 

# **Interactive Intelligence, Inc.**

# ** **

# **Condensed ConsolidatedStatements of Operations (unaudited)**

# **(inthousands, except per share amounts)**

# ** **

|                                         |   | **Three  Months Ended  March 31,** |   |
|----------------------------------------------|--------|-----------------------------------------|--------|
|                                         |   | **2004**                                |   | **2003** |   |
| Revenues:                                    |   |                                    |   |   |   |
| Software                                     |   | $                                       | 6,993  |   | $ | 8,621 |   |
| Services                                     |   | 6,713                                   |   | 5,763 |   |
| Total revenues                               |   | 13,706                                  |   | 14,384 |   |
| Cost of revenues:                            |   |                                    |   |   |   |
| Software                                     |   | 493                                     |   | 292 |   |
| Services                                     |   | 2,855                                   |   | 3,186 |   |
| Total cost of revenues                       |   | 3,348                                   |   | 3,478 |   |
| Gross profit                                 |   | 10,358                                  |   | 10,906 |   |
| Operating expenses:                          |   |                                    |   |   |   |
| Sales and marketing                          |   | 5,028                                   |   | 5,207 |   |
| Research and development                     |   | 3,278                                   |   | 3,495 |   |
| General and administrative                   |   | 1,871                                   |   | 1,456 |   |
| Restructuring and other charges              |   | 16                                      |   | 448 |   |
| Total operating expenses                     |   | 10,193                                  |   | 10,606 |   |
| Operating income                             |   | 165                                     |   | 300 |   |
| Interest income, net                         |   | 7                                       |   | 53 |   |
| Income before income taxes                   |   | 172                                     |   | 353 |   |
| Income taxes                                 |   | 52                                      |   | 53 |   |
| Net income                                   |   | $                                       | 120    |   | $ | 300 |   |
|                                         |   |                                    |   |   |   |
| Net income per share:                        |   |                                    |   |   |   |
| Basic                                        |   | $                                       | 0.01   |   | $ | 0.02 |   |
| Diluted                                      |   | 0.01                                    |   | 0.02 |   |
|                                         |   |                                    |   |   |   |
| Shares used to compute net income per share: |   |                                    |   |   |   |
| Basic                                        |   | 15,806                                  |   | 15,565 |   |
| Diluted                                      |   | 16,700                                  |   | 15,947 |   |

 

See Notes to Condensed Consolidated FinancialStatements

 

4

----

 

# **InteractiveIntelligence, Inc.**

# ** **

# **Condensed ConsolidatedStatement of Shareholders’ Equity (unaudited)**

# **(inthousands)**

# ** **

|                                              |   |              |   | **Additional** |   | **Accum.  Other** |   |               |   |        |   |
|---------------------------------------------------|--------|-------------------|--------|----------------|--------|-------------------|--------|--------------------|--------|-------------|--------|
|                                              |   | **Common  Stock** |   | **Paid-in**    |   | **Comprehensive** |   | **Accumulated**    |   |        |   |
|                                              |   | **Shares**        |   | **Amount**     |   | **Capital**       |   | **Income  (loss)** |   | **Deficit** |   | **Total** |   |
| Balances, December 31, 2003                  |   | 15,755            |   | $              | 157    |              | $      | 64,696             |   | $           | 280    |   | $ | (61,342 | ) | $ | 3,791 |   |
|                                              |   |              |   |           |   |              |   |               |   |        |   |   |   |
| Issuances of common stock                         |   | 30                |   | —         |   | 72                |   | —             |   | —      |   | 72 |   |
| Exercise of stock options                         |   | 32                |   | 1              |   | 83                |   | —             |   | —      |   | 84 |   |
| Amortization of deferred stock-based compensation |   | —            |   | —         |   | 3                 |   | —             |   | —      |   | 3 |   |
| Comprehensive income (loss):                      |   |              |   |           |   |              |   |               |   |        |   |   |   |
| Unrealized loss on foreign currency               |   | —            |   | —         |   | —            |   | (112               | )      | —      |   | (112 | ) |
| Net income                                        |   | —            |   | —         |   | —            |   | —             |   | 120         |   | 120 |   |
| Total comprehensive income (loss)                 |   | —            |   | —         |   | —            |   | (112               | )      | 120         |   | 8 |   |
|                                              |   |              |   |           |   |              |   |               |   |        |   |   |   |
| Balances, March 31, 2004                     |   | 15,817            |   | $              | 158    |              | $      | 64,854             |   | $           | 168    |   | $ | (61,222 | ) | $ | 3,958 |   |

 

# **See Notesto Condensed Consolidated Financial Statements**

 

5

----

 

# **InteractiveIntelligence, Inc.**

 

# **Condensed ConsolidatedStatements of Cash Flows (unaudited)**

# **(inthousands)**

# ** **

|                                                                               |   | **Three  Months Ended  March 31,** |   |
|------------------------------------------------------------------------------------|--------|-----------------------------------------|--------|
|                                                                               |   | **2004**                                |   | **2003** |   |
|                                                                               |   |                                    |   |   |   |
| **Operating  activities:**                                                         |   |                                    |   |   |   |
| Net income                                                                         |   | $                                       | 120    |   | $ | 300 |   |
| Adjustments to reconcile net income to net  cash provided by operating activities: |   |                                    |   |   |   |
| Depreciation                                                                       |   | 873                                     |   | 1,278 |   |
| Amortization                                                                       |   | 3                                       |   | 24 |   |
| Changes in operating assets and  liabilities:                                      |   |                                    |   |   |   |
| Accounts receivable                                                                |   | 1,610                                   |   | (1,829 | ) |
| Prepaid expenses                                                                   |   | (302                                    | )      | 168 |   |
| Other current assets                                                               |   | (221                                    | )      | (23 | ) |
| Other assets                                                                       |   | (40                                     | )      | 4 |   |
| Accounts payable and accrued liabilities                                           |   | (12                                     | )      | 131 |   |
| Accrued compensation and related expenses                                          |   | 77                                      |   | 289 |   |
| Deferred software revenues                                                         |   | (495                                    | )      | (417 | ) |
| Deferred services revenues                                                         |   | (151                                    | )      | 2,445 |   |
| Net cash provided by operating activities                                          |   | 1,462                                   |   | 2,370 |   |
|                                                                               |   |                                    |   |   |   |
| **Investing  activities:**                                                         |   |                                    |   |   |   |
| Purchases of property and equipment                                                |   | (364                                    | )      | (1,182 | ) |
| Sales of available-for-sale investments                                            |   | 3,008                                   |   | 5,502 |   |
| Net cash provided by investing activities                                          |   | 2,644                                   |   | 4,320 |   |
|                                                                               |   |                                    |   |   |   |
| **Financing  activities:**                                                         |   |                                    |   |   |   |
| Repayments on line of credit, net                                                  |   | (1,600                                  | )      | — |   |
| Proceeds from issuance of common stock                                             |   | 72                                      |   | 91 |   |
| Proceeds from stock options exercised                                              |   | 84                                      |   | — |   |
| Net cash provided (used) by financing  activities                                  |   | (1,444                                  | )      | 91 |   |
|                                                                               |   |                                    |   |   |   |
| Net increase in cash and cash equivalents                                          |   | 2,662                                   |   | 6,781 |   |
| Cash and cash equivalents, beginning of  period                                    |   | 12,461                                  |   | 5,913 |   |
| Cash and cash equivalents, end of period                                           |   | $                                       | 15,123 |   | $ | 12,694 |   |
|                                                                               |   |                                    |   |   |   |
| Cash paid for interest                                                             |   | $                                       | 13     |   | $ | 6 |   |
| Cash paid for taxes                                                                |   |                                    | 3      |   |   | 1 |   |

 

See Notes to Condensed Consolidated FinancialStatements

 

6

----

 

# **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 IP Telephony

•                  Unified Communications, and

•                  Self-service Automation.

 

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.

 

Principal operations of the Company commenced during 1997. Since then,the Company has established wholly-owned subsidiaries in Australia, France, theNetherlands and the United Kingdom. The Company also currently has branchoffices in Canada, Germany, Hong Kong, Japan, Korea, Malaysia, Singapore, Spainand Sweden. The Company markets its software applications in North America,Central America, South America, Europe, Asia/Pacific, Australia and SouthAfrica.

 

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 andregulations of the Securities and Exchange Commission. In our opinion, thestatements include all adjustments necessary (which are of a normal andrecurring nature) for the fair presentation of the results of the interimperiods 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 our auditedconsolidated financial statements for the year ended December 31, 2003,included in the Company’s Form 10-K for the year ended December 31, 2003,filed with the Securities and Exchange Commission on March 25, 2004. Ourresults of operations for any interim period are not necessarily indicative ofthe results of operations for any other interim period or for a full fiscalyear.

 

# **2.**              Net Income 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. 28, *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.

 

7

----

 

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

 
|                                                     |   | **Three  Months Ended  March 31,** |   |
|----------------------------------------------------------|--------|-----------------------------------------|--------|
|                                                     |   | **2004**                                |   | **2003** |   |
|                                                     |   |                                    |   |   |   |
| Net income (A)                                           |   | $                                       | 120    |   | $ | 300 |   |
|                                                     |   |                                    |   |   |   |
| Weighted average outstanding shares of  common stock (B) |   | 15,806                                  |   | 15,565 |   |
| Dilutive effect of options to purchase  common stock     |   | 894                                     |   | 382 |   |
| Common stock and common stock equivalent  shares (C)     |   | 16,700                                  |   | 15,947 |   |
|                                                     |   |                                    |   |   |   |
| Net income per share:                                    |   |                                    |   |   |   |
| Basic (A/B)                                              |   | $                                       | 0.01   |   | $ | 0.02 |   |
| Diluted (A/C)                                            |   |                                    | 0.01   |   |   | 0.02 |   |

 

The Company’s calculation of diluted net income per share for the threemonths ended March 31, 2004 and March 31, 2003, respectively,excludes 2.1 million and 2.4 million options to purchase common stock withexercise prices ranging from $5.53 to $50.50 and $3.06 to $50.50 as theireffect was antidilutive.

 

# **3.**              Stock-Based Compensation

 

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 included below illustratesthe effect on net income and net income 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).

 
|                                                                                                                                |   | **Three  Months Ended  March 31,** |   |
|-------------------------------------------------------------------------------------------------------------------------------------|--------|-----------------------------------------|--------|
|                                                                                                                                |   | **2004**                                |   | **2003** |   |
|                                                                                                                                |   |                                    |   |   |   |
| Net income, as reported                                                                                                             |   | $                                       | 120    |   | $ | 300 |   |
| Add: Stock-based compensation expense  included in reported net income, net of related tax effects                                  |   | 3                                       |   | 23 |   |
| Deduct: Total stock-based compensation  expense determined under fair value based method for all awards, net of  related tax effect |   | (769                                    | )      | (1,389 | ) |
| Pro forma net loss                                                                                                                  |   | $                                       | (646   | ) | $ | (1,066 | ) |
|                                                                                                                                |   |                                    |   |   |   |
| Net income (loss) per share:                                                                                                        |   |                                    |   |   |   |
| Basic – as reported                                                                                                            |   | $                                       | 0.01   |   | $ | 0.02 |   |
| Diluted – as reported                                                                                                          |   | 0.01                                    |   | 0.02 |   |
| Basic – pro forma                                                                                                              |   | (0.04                                   | )      | (0.07 | ) |
| Diluted – pro forma                                                                                                            |   |                                    | (0.04  | ) |   | (0.07 | ) |

 

8

----

 

# **4.**              Concentration of Credit Risk

 

One reseller represented 17% of accounts receivableas of March 31, 2004 and one customer represented approximately 16% oftotal revenues and 29% of accounts receivable for the three months endedMarch 31, 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.  TheCompany believes these claims and legal proceedings can be resolved without amaterial adverse effect on its business, financial condition or results ofoperations; however, the Company cannot provide assurance as to theoutcome.  Litigation in general, andintellectual property litigation in particular, can be expensive and disruptiveto normal business operations. Moreover, the results of complex legalproceedings are difficult to predict.

 

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 the technology subject to this claim is not significant to thesoftware it licenses. There is on-going communication between the Company andthe consulting firm to resolve this matter. The Company believes that this matter can be resolved without a materialadverse effect on its business, financial condition or results of operations;however, the Company cannot provide 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.

 

On September 30, 2003, Recursion Software, Inc. filed suit in DallasCounty Court in Dallas, Texas against the Company alleging breach of contractand 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 haspreviously been paid and accrued. As of March 31, 2004, the assessmentrelated to VAT was approximately $2.8 million and the assessment related tocorporation taxes was approximately $366,000. The Company’s tax counsel hasassessed the possibility of the Company paying the assessment related to VAT asremote and the assessment related to corporation taxes as reasonably possible;the Company has not accrued for these amounts. The Company is appealing theassessments, but cannot assure you that these matters will be resolved withoutlitigation or that it will not have to pay some or all of the assessments.

 

9

----

 

# **6.**              Restructuring Charges

# ** **

In February 2003, the Company announced its plan to downsize andreorganize resources in Europe, the Middle East, and the African (“EMEA”)region. The French office was significantly affected, with most positions movedor eliminated. The Company determined that the severance payments and relatedlegal fees incurred qualified as restructuring costs in accordance with FASBStatement No. 146, *Accounting for CostsAssociated 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 asettlement is reached.

 

The Company recognized restructuring charges in accordance with FASBStatement No. 146 of $16,000 and $448,000 for the three months endedMarch 31, 2004 and March, 31 2003, respectively.

 

A summary of the beginning accrued restructuring charges, expensedamount, cash payments and the ending accrued restructuring  charges for the three months endedMarch 31, 2004 is presented below (inthousands).

 
|               |   | **Beginning  Balance** |   | **Expense** |   | **Cash  Payments** |   | **Ending  Balance** |   |
|--------------------|--------|------------------------|--------|-------------|--------|--------------------|--------|---------------------|--------|
| EMEA restructuring |   | $                      | 549    |        | $      | 16                 |   | $                   | (132   | ) | $ | 433 |   |
| Headquarters       |   | 267                    |   | —      |   | (252               | )      | 15                  |   |
| Total              |   | $                      | 816    |        | $      | 16                 |   | $                   | (384   | ) | $ | 448 |   |

 

# **7.**              Recent Accounting Pronouncements

 

In May 2003, the FASB issued FASB Statement No. 150, *Accounting for Certain Financial Instruments withCharacteristics of both Liabilities and Equity*. This Statementestablishes standards for classification and measurement of certain financialinstruments with characteristics of both liabilities and equity. TheStatement also includes required disclosures for financial instruments withinits scope. For the Company, the Statement was effective for financialinstruments entered into or modified after May 31, 2003, and otherwise waseffective as of January 1, 2004, except for mandatorily redeemable financialinstruments. For certain mandatorily redeemable financial instruments, theStatement will be effective for the Company on January 1, 2005. Theeffective date has been deferred indefinitely for certain other types ofmandatorily redeemable financial instruments. The Company currently does nothave any financial instruments that are within the scope of this Statement.

 

10

----

 

In December 2003, the FASB issued FASB Interpretation No. 46(revised December 2003), *Consolidationof Variable Interest Entities,*which addresses how a businessenterprise should evaluate whether it has a controlling  financial interest in an entity throughmeans other than voting rights and accordingly should consolidate the entity.FASB Interpretation No. 46R replaces FASB Interpretation No. 46, *Consolidation of Variable Interest**Entities*,which was issued in January 2003. The Company will be required to applyFASB Interpretation No. 46R to interests in variable interest entities (VIEs)created after December 31, 2003. For variable interests in VIEs createdbefore January 1, 2004, the Interpretation was applied beginning onJanuary 1, 2004. For any VIEs that must be consolidated under FASBInterpretation No. 46R that were created before January 1, 2004, theassets, liabilities and noncontrolling interests of the VIE initially would bemeasured at their carrying amounts with any difference between the net amountadded to the balance sheet and any previously recognized interest beingrecognized as the cumulative effect of an accounting change. If determining thecarrying amounts is not practicable, fair value at the date FASB InterpretationNo. 46R first applies may be used to measure the assets, liabilities andnoncontrolling interest of the VIE. The Company does not hold any interests inVIEs.

 

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

 

### **Forward-Looking Information**

 

Certain statements in this Form 10-Q contain “forward-looking”information (as defined in Section 27A of the Securities Act of 1933, 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, amongothers. We are a global software provider with presence in North America, EMEAand Asia/Pacific.

 

### **Financial Highlights**

 

In the initial years after we began licensing our softwareapplications, our revenue growth was substantial. In 2002 and 2003, we saw adecrease in worldwide spending on technology given the global economicslowdown, and as a result, 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. 

 

Revenue recognized in the first three months of 2004 is the secondhighest quarterly revenue since inception. The information below shows ourtotal revenues and percentage growth from the previous year since salescommenced (revenues in millions).

 

11

----

 
| **Year**                           |   |   | **Revenues** |   | **% Growth** |   |
|------------------------------------|--------|--------|--------------|--------|--------------|--------|
| 2004 (through March 31, 2004) |   | $      | 13.7         |   | 6            | %(1)   |
| 2003                               |   | 51.5   |         | 8      |         |
| 2002                               |   | 47.8   |         | 0      |         |
| 2001                               |   | 47.9   |         | 76     |         |
| 2000                               |   | 27.3   |         | 43     |         |
| 1999                               |   | 19.1   |         | 112    |         |
| 1998                               |   | 9.0    |         | 467    |         |
| 1997                               |   | 1.6    |         | n/a    |         |
|                                    |        |        |              |        |              |        |  |

 

----

(1)  Percent growth shown is forthe three months ended March 31, 2004 compared to the three months endedDecember 31, 2003.

 

Operating expenses decreased approximately $400,000 for the threemonths ended March 31, 2004 compared to the three months endedMarch 31, 2003. The improvement was a result of cost reduction andcontainment efforts that included staff reductions.

 

We had approximately $15.1 million of cash and short-term investmentsas of March 31, 2004. We had borrowings from a line of credit as ofMarch 31, 2004 of $1.2 million, but have since repaid the line in full. Webelieve that as our revenues grow and our expenses remain controlled, we willincrease our liquidity and position ourselves for growth in the future. Ifrevenues remain stagnant or decrease, our liquidity position may weaken, whichwould result in the need to raise capital, either through the capital marketsor debt financings.

 

### **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 months endedMarch 31, 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  March 31,** |   |
|---------------------------------|--------|-----------------------------------------|--------|
|                            |   | **2004**                                |   | **2003** |   |
| Revenues:                       |   |                                    |   |   |   |
| Software                        |   | 51                                      | %      | 60 | % |
| Services                        |   | 49                                      |   | 40 |   |
| Total revenues                  |   | 100                                     |   | 100 |   |
| Cost of revenues:               |   |                                    |   |   |   |
| Software                        |   | 3                                       |   | 2 |   |
| Services                        |   | 21                                      |   | 22 |   |
| Total cost of revenues          |   | 24                                      |   | 24 |   |
| Gross Profit                    |   | 76                                      |   | 76 |   |
| Operating expenses:             |   |                                    |   |   |   |
| Sales and marketing             |   | 37                                      |   | 37 |   |
| Research and development        |   | 24                                      |   | 24 |   |
| General and administrative      |   | 14                                      |   | 10 |   |
| Restructuring and other charges |   | —                                  |   | 3 |   |
| Total operating expenses        |   | 75                                      |   | 74 |   |
| Operating income                |   | 1                                       |   | 2 |   |
| Interest income, net            |   | —                                  |   | — |   |
| Income before income taxes      |   | 1                                       |   | 2 |   |
| Income taxes                    |   | —                                  |   | — |   |
| Net income                      |   | 1                                       | %      | 2 | % |

 

12

----

 

**Comparisonof Three Months Ended March 31, 2004 and 2003**

 

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

 

## *Software Revenues*

## * *

|                         |   | **Three  Months Ended  March 31,** |   |
|------------------------------|--------|-----------------------------------------|--------|
|                         |   | **2004**                                |   | **2003** |   |
|                         |   | **($ in  thousands)**                   |   |
| Software revenues            |   | $                                       | 6,993  |   | $ | 8,621 |   |
| Change from prior year       |   | (19                                     | )%     | 14 | % |
| Percentage of total revenues |   | 51                                      | %      | 60 | % |
|                              |        |                                         |        |  |  |  |  |

 

The decrease in software revenues and percent of software revenues tototal revenues is related primarily to a perpetual license agreement with onecustomer, which accounted for 27% of software revenues in the three monthsended March 31, 2003. Without this license agreement in 2003, softwarerevenues would have increased slightly for the first three months of 2004compared to the first three months of 2003.

 

Beginning in the fourth quarter of 2003, we began offering perpetuallicenses to our new customers and therefore the recognition of revenue on newcontracts signed in 2004 was accelerated compared to how revenue was recognizedunder annually renewable licenses in 2003. Some customers prefer a perpetuallicense, therefore the decision to offer customers perpetual licenses was apart of other actions designed to improve our customer licensing process andmay result in the acceleration of revenue recognition.

 

## *Services Revenues*

 
|                         |   | **Three  Months Ended  March 31,** |   |
|------------------------------|--------|-----------------------------------------|--------|
|                         |   | **2004**                                |   | **2003** |   |
|                         |   | **($ in  thousands)**                   |   |
| Services revenues            |   | $                                       | 6,713  |   | $ | 5,763 |   |
| Change from prior year       |   | 16                                      | %      | 32 | % |
| Percentage of total revenues |   | 49                                      | %      | 40 | % |
|                              |        |                                         |        |  |  |  |  |

 

The increase in services revenues was primarily due to increases in ourgrowing installed base of customers and related payments of annual licenserenewal fees and ongoing maintenance from perpetual licenses. As we sign andinstall new customers, our services revenues should grow, if existing customerscontinue to renew licenses and pay for maintenance on our softwareapplications. The percent of services revenues to total revenues grew due tothe decrease in software revenues (as described above) coupled with theincreasing services revenues.

 

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

 
|                                      |   | **Three  Months Ended  March 31,** |   |
|-------------------------------------------|--------|-----------------------------------------|--------|
|                                      |   | **2004**                                |   | **2003** |   |
|                                      |   | **($ in  thousands)**                   |   |
| Cost of revenues:                         |   |                                    |   |   |   |
| Software                                  |   | $                                       | 493    |   | $ | 292 |   |
| Services                                  |   | 2,855                                   |   | 3,186 |   |
| Total cost of revenues                    |   | $                                       | 3,348  |   | $ | 3,478 |   |
| Total change from prior year              |   | (4                                      | )%     | 6 | % |
| Software costs as a% of software revenues |   | 7                                       | %      | 3 | % |
| Services costs as a% of services revenues |   | 43                                      | %      | 55 | % |

 

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

 

13

----

 

increase in the software costs as a percent of related software revenuesfor the three months ended March 31, 2004 compared to the three monthsended March 31, 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 as a percent of related services revenues was a result of ourfocus on cost control and increases in the related services revenues.

 

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

 
|                         |   | **Three  Months Ended  March 31,** |   |
|------------------------------|--------|-----------------------------------------|--------|
|                         |   | **2004**                                |   | **2003** |   |
|                         |   | **($ in  thousands)**                   |   |
| Gross profit                 |   | $                                       | 10,358 |   | $ | 10,906 |   |
| Change from prior year       |   | (5                                      | )%     | 26 | % |
| Percentage of total revenues |   | 76                                      | %      | 76 | % |
|                              |        |                                         |        |  |  |  |  |

 

Gross profit decreased slightly for the three months endedMarch 31, 2004 compared to the three months ended March 31, 2003.This was a result of a decrease in total revenues due to one large perpetuallicense agreement recognized in 2003, offset by a reduction in cost of revenuesresulting from our focus on cost control, as described above.

 

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

 

## *Sales and Marketing*

 
|                            |   | **Three  Months Ended  March 31,** |   |
|---------------------------------|--------|-----------------------------------------|--------|
|                            |   | **2004**                                |   | **2003** |   |
|                            |   | **($ in  thousands)**                   |   |
| Sales and marketing expenses    |   | $                                       | 5,028  |   | $ | 5,207 |   |
| Change from prior year          |   | (3                                      | )%     | (6 | )% |
| Percentage of total revenues    |   | 37                                      | %      | 37 | % |
| Percentage of software revenues |   | 72                                      | %      | 60 | % |
|                                 |        |                                         |        |  |  |  |  |

 

## *Research and Development*

 
|                              |   | **Three  Months Ended  March 31,** |   |
|-----------------------------------|--------|-----------------------------------------|--------|
|                              |   | **2004**                                |   | **2003** |   |
|                              |   | **($ in  thousands)**                   |   |
| Research and development expenses |   | $                                       | 3,278  |   | $ | 3,495 |   |
| Change from prior year            |   | (6                                      | )%     | (11 | )% |
| Percentage of total revenues      |   | 24                                      | %      | 24 | % |
|                                   |        |                                         |        |  |  |  |  |

 

Sales and marketing and research and development expenses are comprisedprimarily of compensation expenses. We initiated cost control efforts includingstaff reductions in 2002 and 2003, which resulted in lower compensationexpenses for the three months ended March 31, 2004 compared to the threemonths ended March 31, 2003. Sales and marketing expenses as a percentageof software revenues increased for the three months ended March 31, 2004 duemainly to a decrease in software revenues in 2004 as described above.

 

14

----

 

## *General and Administrative*

 
|                                |   | **Three  Months Ended  March 31,** |   |
|-------------------------------------|--------|-----------------------------------------|--------|
|                                |   | **2004**                                |   | **2003** |   |
|                                |   | **($ in  thousands)**                   |   |
| General and administrative expenses |   | $                                       | 1,871  |   | $ | 1,456 |   |
| Change from prior year              |   | 29                                      | %      | (3 | )% |
| Percentage of total revenues        |   | 14                                      | %      | 10 | % |
|                                     |        |                                         |        |  |  |  |  |

 

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 months ended March 31, 2004 compared to the three months endedMarch 31, 2003. This increase is principally the result of hiring generalcounsel in the third quarter of 2003, which increased compensation expense, andan increase in outside legal expenses due to increased efforts to resolvelitigation and other claims against the Company. See Note 5 of Notes toCondensed Consolidated Financial Statements.

 

## *Restructuring and Other Charges*

 
|                            |   | **Three  Months Ended  March 31,** |   |
|---------------------------------|--------|-----------------------------------------|--------|
|                            |   | **2004**                                |   | **2003** |   |
|                            |   | **($ in  thousands)**                   |   |
| Restructuring and other charges |   | $                                       | 16     |   | $ | 448 |   |
| Change from prior year          |   | (96                                     | )%     | 100 | % |
| Percentage of total revenues    |   | —                                  |   | 3 | % |
|                                 |        |                                         |        |  |  |  |  |

 

Restructuring and other charges for the three months endedMarch 31, 2004 and 2003 relate primarily to staff reductions in ourEuropean operations which occurred in 2003. We expect to incur some additionalexpenses related to the restructuring of international operations in 2004;however, at this time, we do not expect the amount to be significant. See Note6 of Notes to Condensed Consolidated Financial Statements. Although we do notcurrently believe that we will need to further reduce staff, the state of theeconomy and resulting technology spending by businesses, among other factors,could result in further reductions.

 

##### ***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  March 31,** |   |
|--------------------------------------------------------------|--------|-----------------------------------------|--------|
|                                                         |   | **2004**                                |   | **2003** |   |
|                                                         |   | **($ in  thousands)**                   |   |
| Cash, cash equivalents and short-term  investments (average) |   | $                                       | 15,296 |   | $ | 15,907 |   |
| Interest income                                              |   | 20                                      |   | 59 |   |
| Return on investment                                         |   | .5                                      | %      | 1.5 | % |
|                                                              |        |                                         |        |  |  |  |  |

 

The decrease in interest income for the three months endedMarch 31, 2004 from the three months ended March 31, 2003 was relatedmainly to a decrease in interest rates and partially to the mix of investments.In 2003, short-term investments were a greater proportion of the total, whilein 2004 all cash was held in cash and cash equivalents accounts. Cash and cashequivalents earn a lower rate of return than short-term investments. We optedto invest in this more liquid mix of investments in 2004 in order to ensure theavailability of our cash.

 

15

----

 

##### ***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 to annual licenserenewals, maintenance and other services revenues. We also have in place a $3million line of credit, of which we had utilized $1.2 million as ofMarch 31, 2004. We use cash primarily for paying our employees (includingsalaries, commissions, benefits and severance), leasing office space,reimbursing travel expenses, paying insurance premiums, remitting applicabletaxes and paying vendors for services rendered and supplies purchased. Inaddition, we purchase property and equipment, including furnishing our newworldwide 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 improved as of March 31, 2004compared with our position as of December 31, 2003 and we believe thatwhen combined with our anticipated cash flows from operations, will besufficient to satisfy our cash needs over the next 12 months. If cash flowsfrom operations are less than anticipated or we have additional cash needs(such as an unfavorable outcome in legal proceedings), our liquidity may not besufficient to cover our needs. In this case, we may be forced to raiseadditional capital, either through the capital markets or debt financings. Wemay not be able to receive favorable terms in raising this capital.

 
|                      |   | **March 31,  2004** |       | **December 31,  2003** |   |
|---------------------------|--------|--------------------------|------------|-----------------------------|--------|
|                      |   | **($ in  thousands )**   | ** ** |
| Cash and cash equivalents |   | $                        | 15,123     |                        | $      | 12,461 |   |
| Short-term investments    |   | —                   |       | 3,008                       |   |
| Line of credit            |   | (1,200                   | )          | (2,800                      | )      |
| Total liquidity           |   | $                        | 13,923     |                        | $      | 12,669 |   |

 

Our operating activities resulted in a net cash inflow of $1.6 millionfor the three months ended March 31, 2004 compared with a net cash inflowof $2.4 million for the three months ended March 31, 2003. These inflowsconsisted mainly of net income and non-cash items such as depreciation. Inaddition, accounts receivable decreased $1.6 million as of March 31, 2004and deferred services revenues increased $2.4 million as of March 31,2003, which both had positive impacts on cash provided by operating activities.Depreciation was $873,000 and $1.3 million for the three months endedMarch 31, 2004 and 2003, respectively.

 

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 $364,000 and $1.2million in the three months ended March 31, 2004 and 2003, respectively.

 

The net repayment on our line of credit resulted in a $1.6 million useof cash for the three months ended March 31, 2004 because we borrowed lesson our line of credit as compared to December 31, 2003.

 

**CriticalAccounting 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.

 

16

----

 

##### ***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 our financialstatements because of their materiality to our statements as a whole andbecause of the judgment required in determining if revenue recognition criteriahave been met.

 

*Software Revenues*

 

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

 

•                  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 evidence ofthe 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 actual renewal feerates. After the initial license period, our customers may renew their licenseagreement for an additional period, typically 12 months, by paying a renewalfee. Under perpetual software license agreements, we recognize annualmaintenance fees as services revenues ratably over the post-contractmaintenance period, which is typically 12 months.

 

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 and ultimately terminating the customer’s license(s) and/or thecustomer’s and reseller’s access to future upgrades, licenses and customersupport. Once all collection efforts are exhausted, the receivable is writtenoff against the allowance for doubtful accounts.

 

17

----

 

##### ***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 March 31, 2004, allresearch and development costs have been expensed.

 

### **Recently Issued Accounting Standards**

 

In May 2003, the FASB issued FASB Statement No. 150, *Accounting for Certain Financial Instruments withCharacteristics of both Liabilities and Equity*. This Statementestablishes standards for classification and measurement of certain financialinstruments with characteristics of both liabilities and equity. TheStatement also includes required disclosures for financial instruments within itsscope. For us, the Statement was effective for financial instrumentsentered into or modified after May 31, 2003, and otherwise was effectiveas of January 1, 2004, except for mandatorily redeemable financialinstruments. For certain mandatorily redeemable financial instruments, theStatement will be effective for us on January 1, 2005. The effective datehas been deferred indefinitely for certain other types of mandatorilyredeemable financial instruments. We currently do not have any financial instrumentsthat are within the scope of this Statement.

 

In December 2003, the FASB issued FASB Interpretation No. 46(revised December 2003), *Consolidationof Variable Interest Entities,*which addresses how a businessenterprise should evaluate whether it has a controlling  financial interest in an entity throughmeans other than voting rights and accordingly should consolidate the entity.FASB Interpretation No. 46R replaces FASB Interpretation No. 46, *Consolidation of Variable Interest**Entities*,which was issued in January 2003. We will be required to apply FASBInterpretation No. 46R to interests in variable interest entities (VIEs)created after December 31, 2003. For variable interests in VIEs createdbefore January 1, 2004, the Interpretation was applied beginning onJanuary 1, 2004. For any VIEs that must be consolidated under FASBInterpretation No. 46R that were created before January 1, 2004, theassets, liabilities and noncontrolling interests of the VIE initially would bemeasured at their carrying amounts with any difference between the net amountadded to the balance sheet and any previously recognized interest beingrecognized as the cumulative effect of an accounting change. If determining thecarrying amounts is not practicable, fair value at the date FASB InterpretationNo. 46R first applies may be used to measure the assets, liabilities andnoncontrolling interest of the VIE. We do not hold any interests in VIEs.

 

# **Factorsthat may affect our future operating results are set forth below:**

 

# **THEOVERALL ECONOMIC CLIMATE MAY BE WEAK**

 

Our products typically represent substantial capital commitments bycustomers and  involve a potentiallylong sales cycle. As a result, customer purchase decisions may be significantlyaffected by a variety of factors, including general economic trends in theallocation of capital spending budgets to communication software, services andsystems, lengthened sales cycles, customer approval processes, and marketconditions, which have resulted in many of our customers delaying and/orreducing their capital spending related to information systems. If the economyis weak, demand for our products could decrease, resulting in lower revenues.

 

# **WEHAVE HISTORICALLY INCURRED LOSSES AND WE MAY NOT SUSTAIN PROFITABILITY**

 

Since inception, the first quarters of 2004 and 2003 were the onlyquarters we have been profitable. We incurred net income of $120,000 in thequarter ended March 31, 2004 and net losses of $5.9 million,$7.7 million and $11.0 million for the years ended December 31,2003, 2002 and 2001, respectively. At March 31, 2004, we had accumulatednet losses since inception of $61.2 million. We intend to continue to makesignificant investments in our research and development, marketing, servicesand sales operations.

 

18

----

 

Certain of these expenses will precede generation of revenues. As aresult, we may continue to experience losses and/or negative cash flow fromoperations in future quarters.

 

# **OURQUARTERLY OPERATING RESULTS HAVE VARIED SIGNIFICANTLY**

 

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 ourproducts during 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.

 

# **WEHAVE A LENGTHY PRODUCT SALES CYCLE WHICH HAS CONTRIBUTED AND MAY CONTINUE TOCONTRIBUTE TO THE VARIABILITY OF QUARTERLY OPERATING 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 by customersabout the introduction of new products by us or our competitors; and

 

19

----

 

•                  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.

 

# **OURINABILITY TO SUCCESSFULLY MANAGE OUR INCREASINGLY COMPLEX THIRD PARTYRELATIONSHIPS 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.

 

# **WEFACE COMPETITIVE PRESSURES, WHICH MAY HAVE A 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 telephonyplatform developers, computer telephony applications software developers and telecommunicationsequipment vendors. We cannot assure you that we will be able to competeeffectively against current and future competitors. In addition, increasedcompetition or other competitive pressures may result in price reductions,reduced margins or loss of market share, any of which could have a materialadverse effect on our business, financial condition or results of operations.

 

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 installedbase of customers than we do. As a result, these competitors may be able torespond to new or emerging technologies and changes in customer requirements fasterand more effectively than we can, or to devote greater resources to thedevelopment, promotion and sale of products than we can. Current and potentialcompetitors have established, and may in the future establish, cooperativerelationships among themselves or with third parties, including mergers oracquisitions, to increase the ability of their products to address the needs ofour current or prospective customers. If these competitors were to acquiresignificant market share, it could have a material adverse effect on ourbusiness, financial condition or results of operations.

 

# **WEMAY NOT BE ABLE TO GROW OUR BUSINESS IF WE DO NOT MAINTAIN SUCCESSFULRELATIONSHIPS WITH OUR RESELLERS AND OEM PARTNERS AND CONTINUE TO RECRUIT ANDDEVELOP ADDITIONAL SUCCESSFUL RESELLERS AND OEM PARTNERS**

# ** **

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 additional resellersand OEM partners. We rely primarily on resellers to market and support ourproducts and plan on continuing to rely heavily on such partners in the future.We are still developing our reseller and OEM distribution networks and may beunable to attract additional resellers with both voice and data expertise orappropriate OEM partners that will be able to market our products effectivelyand that will be qualified to provide timely and cost-effective customersupport and service. We generally do not have long-term or exclusive agreementswith our resellers or OEM partners, and the loss of specific larger

 

20

----

 

resellers or OEM partners or a significant number of resellers or OEMpartners could materially adversely affect our business, financial condition orresults of operations.

 

# **OURMARKETS ARE CHARACTERIZED BY RAPID TECHNOLOGICAL CHANGE WHICH MAY CAUSE US TOINCUR SIGNIFICANT DEVELOPMENT COSTS AND PREVENT US FROM ATTRACTING NEWCUSTOMERS**

# ** **

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.

 

# **OURBUSINESS WILL BE ADVERSELY AFFECTED IF WEB-BASED ELECTRONIC BUSINESS SOLUTIONSARE NOT WIDELY UTILIZED**

# ** **

Our products address a market for Web-based, interactive electronicbusiness solutions. Therefore, our future success depends on the widespreadadoption of the Web as a primary medium for commerce and business applications.The failure of this market to expand, or a delay in the development of thismarket, could have a material adverse effect on our business, financialcondition or results of operations. The Web has experienced, and is expected tocontinue to experience, significant user and traffic growth, which has, attimes, caused user frustration with slow access and download times. The Webinfrastructure may not be able to support the demands placed on it by thecontinued growth on which our success depends. Moreover, critical issuesconcerning the commercial use of the Web, such as security, reliability, cost,accessibility and quality of service, remain unresolved and may negativelyaffect the growth of Web use or the attractiveness of commerce and businesscommunication over the Web. In addition, the Web could lose its viability dueto delays in the development or adoption of new standards and protocols tohandle increased activity or due to increased government regulation or taxationof Internet commerce.

 

# **ADECLINE IN MARKET ACCEPTANCE FOR MICROSOFT TECHNOLOGIES ON WHICH OUR PRODUCTSRELY COULD HAVE A MATERIAL ADVERSE EFFECT ON US**

# ** **

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.

 

# **OURFUTURE BUSINESS PROSPECTS DEPEND IN PART ON OUR ABILITY TO MAINTAIN AND IMPROVEOUR CURRENT PRODUCTS AND DEVELOP NEW PRODUCTS**

# ** **

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 inherent in our applications, major new applicationsand application enhancements require long development and testing periods. Wemay not be successful in developing and marketing, on a timely and costeffective basis, application enhancements or new software applications thatrespond to technological change, evolving industry standards or customerrequirements. We may also experience difficulties that could delay or preventthe successful development, introduction or marketing of applicationenhancements, and our new applications and application enhancements may notachieve market acceptance. Significant

 

21

----

 

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.

 

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

# ** **

If the demand 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 andservices to account for the majority of our revenues for the foreseeablefuture. Although we believe demand for the functions performed by our productsis high, the market for our products and services is still emerging. Further,our growth plans require us to successfully attract enterprise and serviceprovider customers in significantly larger numbers than we have historicallyachieved.

 

# **IFOUR CUSTOMERS DO NOT PERCEIVE OUR PRODUCTS OR THE RELATED SERVICES PROVIDED BYUS OR OUR RESELLERS OR OEM PARTNERS TO BE EFFECTIVE OR OF HIGH QUALITY, OURBRAND 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.

 

# **WEMAY NOT BE ABLE TO PROTECT OUR PROPRIETARY RIGHTS ADEQUATELY, WHICH COULD ALLOWTHIRD PARTIES TO COPY OR OTHERWISE OBTAIN AND USE OUR TECHNOLOGY WITHOUTAUTHORIZATION**

# ** **

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 ourtechnology without authorization. A third party could also develop similartechnology independently. In addition, the laws of some countries in which wesell our products do not protect our software and intellectual property rightsto the same extent as the laws of the United States. Unauthorized copying, useor reverse 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 technology oreliminate the affected product function, either of which could have a materialadverse effect on us.

 

# **INFRINGEMENTCLAIMS 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 these

 

22

----

 

products overlap, we believe that software developers may faceadditional infringement claims. See Note 5 of Notes to the CondensedConsolidated Financial 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.

 

# **WEDEPEND ON KEY PERSONNEL AND WILL NEED TO RETAIN AND RECRUIT SKILLED PERSONNEL,FOR WHICH COMPETITION IS INTENSE, TO CONDUCT 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.

 

Also, in connection with our effort to streamline operations, reducecosts and rationalize our staffing and structure, we initiated headcountreductions in both 2001 and 2002 of approximately 10% to12% each year.There were substantial costs associated with the workforce reductions relatedto severance and other employee-related costs, and our restructuring plans maystill yield unanticipated consequences, such as attrition beyond ourimplemented headcount reductions. As a result, our ability to respond tounexpected challenges may be impaired and we may be unable to take advantage ofnew opportunities. These reductions in workforce may reduce employee morale andmay create concern among existing employees about job security, which may leadto increased turnover. These reductions in headcount may still subject us tothe risk of litigation. As a result of these factors, our remaining personnelmay seek employment with larger, more established companies or companies theyperceive as having a greater potential for stock price appreciation.

 

# **WEMAY PURSUE ACQUISITIONS THAT BY THEIR NATURE PRESENT RISKS AND THAT MAY NOT BESUCCESSFUL**

 

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.

•                  We may be unableto integrate acquired businesses successfully and realize anticipated economic,operational and other benefits in a timely manner, particularly if we acquire abusiness in a market in which we have limited or no current expertise, or witha corporate culture different from our own. If we are unable to integrateacquired businesses successfully, we could incur substantial costs and delaysor 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

 

23

----

 

additional debt or be required to recognizeexpense related to intangible 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.

 

# **OURINTERNATIONAL OPERATIONS INVOLVE FINANCIAL 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 thethree months ended March 31, 2004 and the years ended December 31,2003, 2002, and 2001, respectively. To date, our products have been licensedoutside North America primarily in Western Europe, South Africa, and Australia.We also have marketing efforts in Japan, Korea, China and Central and SouthAmerica. We intend to continue to emphasize our international operations and wemay enter additional international markets. Revenues from internationaloperations may be inadequate to cover the expenses of those operations. Inaddition to foreign currency fluctuation risks, other risks inherent in our internationalbusiness activities may include 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.

 

# **FLUCTUATIONSIN THE VALUE OF FOREIGN CURRENCIES 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. Our internationalexpenses are generally denominated in local foreign currencies. Althoughforeign currency translation gains and losses have been immaterial to date,fluctuations in exchange rates between the U.S. dollar and other currenciescould have a material adverse effect on our business, financial condition orresults of operations, and particularly on our operating margins. To date, wehave 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.

 

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

 

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

 

24

----

 

development costs, diversion of technical and other resources from ourother development efforts, or the loss of credibility with current or futurecustomers. This could result in a loss of revenue or delay in market acceptanceof our products, which could have a material adverse effect on our business,financial condition or results of operations.

 

Our license agreements 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.

 

Because our solution currently consists of our software running on aWindows 2000 server and voice processing boards operating in a complex networkenvironment with database servers, email servers and other third party systems,it may be more prone to performance interruptions for our customers thantraditional hardware-based products. Performance interruptions at our customersites, most of which currently do not have back-up systems, could affect demandfor our products or give rise to claims against us.

 

# **WEMAY NOT BE ABLE TO OBTAIN ADEQUATE FINANCING 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.

 

# **OURSTOCK PRICE HAS BEEN AND COULD CONTINUE TO 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.

 

25

----

 

# **OURCOMMON STOCK IS SUBJECT TO VARIOUS LISTING 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. Any delisting may result ina reduction in the liquidity of our common stock, which may have a materialadverse effect on the price of our common stock.

 

# **REGULATORYCHANGES MADE TO ACCOUNTING PRINCIPLES GENERALLY ACCEPTED IN THE UNITED STATESOF AMERICA OR CORPORATE GOVERNANCE MATTERS MAY IMPACT OUR BUSINESS**

 

Revisions to accounting principles generally accepted in the United States of America will require usto review our accounting and financial reporting procedures in order to ensurecontinued compliance with required policies. From time to time, such changesmay have a short-term impact on our reporting, and these changes may impactmarket perception of our financial condition. In addition, legislative changes,and the perception these changes create, can have a material, adverse effect onour 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 thelegal climate may lead to additional liability concerns which may result inincreased insurance costs.

 

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

 

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 and By-Lawsand take other actions requiring the vote or consent of shareholders, includingmergers, going private transactions and other extraordinary transactions, andthe terms of any of these transactions. The ownership position of theseshareholders may have the effect of delaying, deterring or preventing a changein control or a change in the composition of our board of directors.

 

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

 

Our Restated Articles 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.

 

26

----

 

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.

 

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

 

The risks and 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.

 

**Item3. Quantitative and Qualitative****Disclosuresabout Market Risk.**

 

We develop products inthe United States and sell licenses in North America, Europe, the Asia/Pacificregion, South Africa, and Central and South America. As a result, our financialresults could be affected by various factors, including changes in foreigncurrency exchange rates or weak economic conditions in foreign markets. As mostsales are currently made in U.S. dollars, a strengthening of the dollar couldmake our products less competitive in foreign markets. Additionally, as ourbusiness matures in foreign markets, we may offer our products and services incertain other local currencies. As a result, we will be subject to foreigncurrency fluctuations which 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 cash andcash 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 will incur interest expense if theline is utilized.

 

**Item 4. Controls and 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 thetime periods specified in the SEC’s rules and forms. We carried out anevaluation, under the supervision and with the participation of our management,including our President and Chief Executive Officer and our Chief FinancialOfficer and Treasurer, of the effectiveness of the design and operation of ourdisclosure controls and procedures as of March 31, 2004 pursuant to Rule13a-15(b) of the Exchange Act. Based on that evaluation, our President andChief Executive Officer and our Chief Financial Officer and Treasurer concludedthat our disclosure controls and procedures are effective.

 

There have been no changes in our internal control over financialreporting that occurred during the quarter ended March 31, 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 ourbusiness.  We believe these claims andlegal proceedings can be resolved without

 

27

----

 

a material adverse effect on our business, financial condition or resultsof operations; however, we cannot provide assurance as to the outcome.Litigation in general, and intellectual property litigation in particular, canbe expensive and disruptive to normal business operations. Moreover, theresults of complex legal proceedings are difficult to predict.

 

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 the technology subject tothis claim is not significant to the software we license. There is on-goingcommunication between us and the consulting firm to resolve this matter.  We believe that this matter can be resolvedwithout a material adverse effect on our business, financial condition orresults of operations; however, we cannot provide assurance 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 in DallasCounty Court in Dallas, Texas against us alleging breach of contract and moneydue 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 haspreviously been paid and accrued. As of March 31, 2004, the assessmentrelated to VAT was approximately $2.8 million and the assessment related tocorporation taxes was approximately $366,000. Our tax counsel has assessed thepossibility of us paying the assessment related to VAT as remote and theassessment related to corporation taxes as reasonably possible; we have notaccrued for these amounts. We are appealing the assessments, but cannot assureyou that these matters will be resolved without litigation or that we will nothave to pay some or all of the assessments.

 

28

----

 

**Item 6. Exhibits and Reports o****n Form 8-K.**

 

(a)          Exhibits

 

10.13  Employment Agreement between the Company andPamela J. Hynes dated November 4, 1996 and the First Amendment toEmployment Agreement between the Company and Pamela J. Hynes datedFebruary 23, 2000

 

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 theSarbanes-Oxley Act of 2002

 

(b)         Reports on Form 8-K

 

1. On April 20,2004, the Company furnished, not filed, a Form 8-K attaching a press releasedescribing its results of operations for the quarter ended March 31, 2004.

 

29

----

 

**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: May 12, 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) |

 

30

----