** **

**UNITED STATES**

**SECURITIESAND EXCHANGE COMMISSION**

 

**Washington, D.C. 20549**

 

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**FORM 10-Q**

 

| **(Mark  One)** |                                                                                         |
|-----------------|----------------------------------------------------------------------------------------------|
|            |                                                                                         |
| **ý**      | **QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|                 |                                                                                              |  |  |

 

**For the quarterly period ended March31, 2002**

 

**Or**

 

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

 

**For the transition periodfrom             to             **

 

**Commission File Number 000-27385**

 

**INTERACTIVEINTELLIGENCE, INC.**

(Exact name of registrant as specified in its charter)

 

| **Indiana**                                                      |   | **35-1933097**                    |
|------------------------------------------------------------------|--------|-----------------------------------|
| (State or other jurisdiction of   incorporation or organization) |   | (IRS Employer Identification No.) |
|                                                             |   |                              |
| **8909 Purdue Road**                                             |
| **Suite 300**                                                    |
| **Indianapolis, Indiana 46268**                                  |
| (Address of principal executive offices)                         |
|                                                             |   |                              |
| **(317) 872-3000**                                               |
| (Registrant’s telephone number)                             |

 

Indicate by checkmark whether the registrant (1) hasfiled all reports required to be filed by Section 13 or 15(d) of the SecuritiesExchange Act of 1934 during the preceding 12 months (or for such shorter periodthat the registrant was required to file such reports), and (2) has beensubject to such filing requirements for the past 90 days.

 

Yes  ý   No  o

 

The number of shares of common stock outstanding onApril 30, 2002 was 15,380,288.

 

 

TABLE OF CONTENTS

 
| PART I. FINANCIAL INFORMATION |
|-------------------------------|
|                          |   |
| Item  1.                      | Condensed  Consolidated Balance Sheets as of March 31, 2002 and December 31, 2001 |
|                          |   |
|                          | Condensed  Consolidated Statements of Operations for the three months ended March 31,  2002 and 2001 |
|                          |   |
|                          | Condensed  Consolidated Statements of Cash Flows for the three months ended March 31,  2002 and 2001 |
|                          |   |
|                          | Notes  to Condensed Consolidated Financial Statements |
|                          |   |
| Item  2.                      | Management’s  Discussion and Analysis of Financial Condition and Results of Operations |
|                          |   |
| Item  3.                      | Quantitative  and Qualitative Disclosures About Market Risk |
|                          |   |
| PART II. OTHER INFORMATION    |
|                          |   |
| Item 1.                       | Legal Proceedings |
|                          |   |
| Item 6.                       | Exhibits and  Reports on Form 8-K |
|                          |   |
| Signature                     |
|                               |  |  |

 

2

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**PARTI.  FINANCIAL INFORMATION**

 

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

 

**InteractiveIntelligence, Inc.**

 

**CondensedConsolidated Balance Sheets**

**(Inthousands, except share amounts)**

 
|                                                                                                                                                                 |   | **March 31,  2002** |   | **December 31,  2001** |   |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|---------------------|--------|------------------------|--------|
|                                                                                                                                                                 |   |                |   |
|                                                                                                                                                                 |   | **(Unaudited)**     |   |                   |   |
| **Assets**                                                                                                                                                           |   |                |   |                   |   |
| Current assets:                                                                                                                                                      |   |                |   |                   |   |
| Cash and cash  equivalents                                                                                                                                           |   | $                   | 2,418  |                   | $      | 14,503 |   |
| Short-term  investments                                                                                                                                              |   | 9,627               |   | 7,581                  |   |
| Accounts  receivable, net of allowance for doubtful accounts of $729 in 2002 and $677  in 2001                                                                       |   | 9,109               |   | 8,424                  |   |
| Prepaid expenses                                                                                                                                                     |   | 1,131               |   | 1,116                  |   |
| Other current  assets                                                                                                                                                |   | 196                 |   | 223                    |   |
| Total current  assets                                                                                                                                                |   | 22,481              |   | 31,847                 |   |
|                                                                                                                                                                 |   |                |   |                   |   |
| Property and  equipment, net                                                                                                                                         |   | 9,154               |   | 9,598                  |   |
|                                                                                                                                                                 |   |                |   |                   |   |
| Long-term  investments                                                                                                                                               |   | 6,086               |   | —                 |   |
| Other assets,  net                                                                                                                                                   |   | 1,092               |   | 1,064                  |   |
| Total assets                                                                                                                                                         |   | $                   | 38,813 |                   | $      | 42,509 |   |
|                                                                                                                                                                 |   |                |   |                   |   |
| **Liabilities  and shareholders’ equity**                                                                                                                       |   |                |   |                   |   |
| Current  liabilities:                                                                                                                                                |   |                |   |                   |   |
| Accounts payable  and accrued liabilities                                                                                                                            |   | $                   | 3,545  |                   | $      | 3,924 |   |
| Accrued  compensation and related expenses                                                                                                                           |   | 1,078               |   | 1,096                  |   |
| Deferred revenue                                                                                                                                                     |   | 9,551               |   | 9,214                  |   |
| Total current  liabilities                                                                                                                                           |   | 14,174              |   | 14,234                 |   |
|                                                                                                                                                                 |   |                |   |                   |   |
| 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; 15,352,382 issued and outstanding at  March 31, 2002, 15,282,673 issued and outstanding at December 31, 2001 |   | 154                 |   | 153                    |   |
| Additional paid-in  capital                                                                                                                                          |   | 63,674              |   | 63,485                 |   |
| Accumulated  other comprehensive income                                                                                                                              |   | (121                | )      | (13                    | )      |
| Accumulated  deficit                                                                                                                                                 |   | (39,068             | )      | (35,350                | )      |
| Total  shareholders’ equity                                                                                                                                     |   | 24,639              |   | 28,275                 |   |
| Total  liabilities and shareholders’ equity                                                                                                                     |   | $                   | 38,813 |                   | $      | 42,509 |   |

 

See accompanying notes.

 

3

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**Interactive Intelligence, Inc.**

 

**CondensedConsolidated Statements of Operations (unaudited)**

**(Inthousands, except per share amounts)**

 
|                                        |   | **Three months ended  March 31,** |       |
|---------------------------------------------|--------|-----------------------------------|------------|
|                                        |   |                              |
|                                        |   | **2002**                          |       | **2001** |   |
| Revenues:                                   |   |                              |       |   |   |
| Software                                    |   | $                                 | 6,046      |   | $ | 8,912 |   |
| Services                                    |   | 4,352                             |       | 3,760 |   |
| Total revenues                              |   | 10,398                            |       | 12,672 |   |
|                                        |   |                              |       |   |   |
| Costs and  expenses:                        |   |                              |       |   |   |
| Costs of  software                          |   | 328                               |       | 149 |   |
| Costs of  services                          |   | 3,014                             |       | 3,552 |   |
| Sales and  marketing                        |   | 5,431                             |       | 5,434 |   |
| Research and  development                   |   | 3,906                             |       | 3,882 |   |
| General and  administrative                 |   | 1,497                             |       | 1,603 |   |
| Total costs and  expenses                   |   | 14,176                            |       | 14,620 |   |
| Operating loss                              |   | (3,778                            | )          | (1,948 | ) |
|                                        |   |                              |       |   |   |
| Interest income,  net                       |   | 129                               |       | 318 |   |
| Loss before  income taxes                   |   | (3,649                            | )          | (1,630 | ) |
|                                        |   |                              |       |   |   |
| Income taxes                                |   | 69                                |       | 60 |   |
|                                        |   |                              |       |   |   |
| Net loss                                    |   | $                                 | (3,718     | ) | $ | (1,690 | ) |
|                                        |   |                              | ** ** |   | ** ** |
| Net loss per  share:                        |   |                              | ** ** |   | ** ** |
| Basic and  diluted                          |   | $                                 | (0.24      | ) | $ | (0.11 | ) |
|                                        |   |                              |       |   |   |
| Shares used to  compute net loss per share: |   |                              |       |   |   |
| Basic and  diluted                          |   | 15,337                            |       | 14,801 |   |

 

See accompanying notes.

 

4

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**Interactive Intelligence, Inc.**

 

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

**(Inthousands)**

 
|                                                                                    |   | **Three months ended  March 31,** |   |
|-----------------------------------------------------------------------------------------|--------|-----------------------------------|--------|
|                                                                                    |   |                              |
|                                                                                    |   | **2002**                          |   | **2001** |   |
| **Operating  activities**                                                               |   |                              |   |   |   |
| Net loss                                                                                |   | $                                 | (3,718 | ) | $ | (1,690 | ) |
| Adjustments to  reconcile net loss to net cash provided (used) by operating activities: |   |                              |   |   |   |
| Depreciation                                                                            |   | 1,248                             |   | 961 |   |
| Amortization of  deferred stock-based compensation                                      |   | 23                                |   | 19 |   |
| Changes in  operating assets and liabilities:                                           |   |                              |   |   |   |
| Accounts  receivable                                                                    |   | (685                              | )      | 654 |   |
| Prepaid expenses                                                                        |   | (15                               | )      | (245 | ) |
| Other current  assets                                                                   |   | 27                                |   | (85 | ) |
| Accounts payable  and accrued liabilities                                               |   | (379                              | )      | (420 | ) |
| Accrued  compensation and related expenses                                              |   | (18                               | )      | 35 |   |
| Deferred revenue                                                                        |   | 337                               |   | 3,344 |   |
| Net cash  provided (used) by operating activities                                       |   | (3,180                            | )      | 2,573 |   |
|                                                                                    |   |                              |   |   |   |
| **Investing  activities**                                                               |   |                              |   |   |   |
| Purchases of  property and equipment, net                                               |   | (804                              | )      | (1,309 | ) |
| Purchases of  available-for-sale investments                                            |   | (13,613                           | )      | (10,116 | ) |
| Sales of  available-for-sale investments                                                |   | 5,373                             |   | 1,691 |   |
| Change in other  assets                                                                 |   | (28                               | )      | (165 | ) |
| Net cash  provided (used) by investing activities                                       |   | (9,072                            | )      | (9,899 | ) |
|                                                                                    |   |                              |   |   |   |
| **Financing  activities**                                                               |   |                              |   |   |   |
| Principal  payments on capital lease obligations                                        |   | —                            |   | (165 | ) |
| Proceeds from  issuances of common stock                                                |   | 129                               |   | 14,969 |   |
| Proceeds from  stock options exercised                                                  |   | 38                                |   | 188 |   |
| Net cash  provided by financing activities                                              |   | 167                               |   | 14,992 |   |
| Net increase  (decrease) in cash and cash equivalents                                   |   | (12,085                           | )      | 7,666 |   |
|                                                                                    |   |                              |   |   |   |
| Cash and cash  equivalents, beginning of period                                         |   | 14,503                            |   | 1,999 |   |
| Cash and cash  equivalents, end of period                                               |   | $                                 | 2,418  |   | $ | 9,665 |   |

 

See accompanying notes.

 

5

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Interactive Intelligence,Inc

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

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

 

InteractiveIntelligence, Inc. (“I3” or the “Company”) is a leading provider ofsoftware-based interaction management solutions designed to automatecommunications for contact centers, enterprises, and service providers. Basedon an open, unified platform, the Interactive Intelligence product line wasdesigned as a flexible and affordable alternative to traditional telecomsolutions. The Company’s products provide a complete communications solutionincluding PBX (private branch exchange), ACD (automated call distributor), IVR(interactive voice response), unified communications, and Internet and wirelessfunctionality.  The Company currentlyderives substantially all of its revenues from licenses of its InteractionCenter platform products and related services.

 

Principal operations ofthe Company commenced during 1997. Since then, the Company has established wholly-owned subsidiaries inFrance and Australia. The Company also currently has branch offices in Japan,Korea, Malaysia, the Netherlands, and the United Kingdom.   The Company’s products are marketed inNorth America, Central America, South America, Europe, the Asia/Pacific region,Australia, and South Africa.

 

The accompanyingunaudited financial statements have been prepared in conformity with generallyaccepted accounting principles for interim financial information and with theinstructions for Form 10-Q and Article 10 of Regulation S-X.  Accordingly, certain information andfootnote disclosures normally included in financial statements prepared inaccordance with generally accepted accounting principles have been condensed,or omitted, pursuant to the rules and regulations of the Securities andExchange Commission.  In our opinion,the statements include all adjustments necessary  (which are of a normal and recurring nature) for the fairpresentation of the results of the interim periods presented.

 

The balance sheet atDecember 31, 2001 has been derived from the audited financial statements atthat date but does not include all of the information and footnotes required bygenerally accepted accounting principles for complete financial statements.

 

These financialstatements should be read in conjunction with our audited consolidatedfinancial statements for the year ended December 31, 2001, included in theCompany’s Form 10-K for the year ended December 31, 2001, filed with theSecurities and Exchange Commission on April 1, 2002.  Our results of operations for any interim period are notnecessarily indicative of the results of operations for any other interimperiod or for a full fiscal year.

 

**2.****              NetLoss Per Common Share**

 

Basic loss per share iscalculated based on the weighted-average number of outstanding common shares.  Diluted loss per share is calculated basedon the weighted-average number of outstanding common shares plus the effect ofdilutive potential common shares.

 

6

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The following tablepresents the calculation of basic and diluted net loss per share (in thousands,except per share amounts):

 
|                                                         |   | **Three  Months Ended  March 31,** |   |
|--------------------------------------------------------------|--------|------------------------------------|--------|
|                                                         |   |                               |
|                                                         |   | **2002**                           |   | **2001** |   |
|                                                         |   |                               |   |   |   |
| Net Loss:                                                    |   | $                                  | (3,718 | ) | $ | (1,690 | ) |
|                                                         |   |                               |   |   |   |
| Basic and  diluted:                                          |   |                               |   |   |   |
| Weighted-average  shares used to compute net loss per share: |   | 15,337                             |   | 14,801 |   |
|                                                         |   |                               |   |   |   |
| Basic and  diluted net loss per common share:                |   | $                                  | (0.24  | ) | $ | (0.11 | ) |

 

The Company’s calculationof diluted net loss per share excludes potential common shares as the effectwould be antidilutive.  Potential commonshares are composed of shares of common stock of the Company issuable on theexercise of stock options.  Options topurchase 3,305,794 shares of common stock with exercise prices of $0.13 to$50.50 per share were outstanding as of March 31, 2002 and options to purchase2,637,441 shares of common stock with exercise prices of $0.13 to $50.50 pershare were outstanding as of March 31, 2001.

 

**3.****              BankLine of Credit**

 

The Company currently hasan unsecured line of credit with a bank in the amount of $5,000,000 which bearsinterest at the bank’s prime rate (4.75% at March 31, 2002).  As of March 31, 2002, the Company had nooutstanding balance under the line of credit. This line of credit expires June 22, 2002.

 

**4.     Contingencies**

 

In June 1999 andSeptember 1999, the Company received letters from a competitor in the callcenter market claiming that the Company’s products utilize technologiespioneered and patented by that competitor. The Company’s patent counsel has reviewed all of the patents listed inthe letters.  Based on the advice of theCompany’s patent counsel, the Company believes that its products do notinfringe any of the patents listed in either letter.  The Company has discussed its conclusion with the competitor andhas also discussed possible licensing of certain technologies from thecompetitor.  The Company cannot assureyou that this matter can be resolved amicably without litigation, or that itwill ultimately be able to enter into a licensing arrangement on terms andconditions that would not have a material adverse effect on the Company’sbusiness, financial condition or results of operations.

 

In June 2000 and October2001, the Company received letters from a competitor in the outbound callcenter market claiming that the Company’s products utilize technologiespioneered and patented by the competitor. Although the Company’s patent counsel has not determined the validity ofthese patents, the Company has discussed the possible licensing of certain technologiesfrom the competitor.  The Company cannotassure you that these claims can be resolved amicably without litigation, orthat it will be able to enter into licensing arrangements on terms andconditions that would not have a material adverse effect on the Company’sbusiness, financial condition or results of operations.

 

In July 2000, the Companyreceived a letter from Avaya, Inc., a competitor in the call center market,claiming that the Company’s products utilize technologies pioneered andpatented by them.  As a result ofsubsequent discussions, the Company accrued an appropriate amount for thelicensing of certain technologies related to 2001 and prior years in thefinancial statements for the

 

7

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year ended December 31,2001.  An agreement was finalized andexecuted in February 2002 and the Company believes the terms and conditions ofthe licensing arrangement will not have a material adverse effect on theCompany’s business, financial condition or results of operations.

 

From time to time, theCompany is also involved in certain legal proceedings in the ordinary course ofconducting our business. While the ultimate liability, if any, in these actionscannot currently be determined, the Company believes these legal proceedingswill not have a material adverse effect on the Company’s financial position.

 

**Item2.  Management’s Discussion and Analysisof Financial Condition and Results of Operations**

 

*Forward-LookingInformation*

 

Certain statementsin this Form 10-Q contain “forward-looking” information (as defined inSection 27A of the Securities Act of 1933, as amended and Section 21Eof the Securities Exchange Act of 1934, as amended) that involve risks anduncertainties which may cause actual results to differ materially from thosepredicted in the forward-looking statements. Forward-looking statements can beidentified by their use of such verbs as “expects,” “anticipates,” and“believes” or similar verbs or conjugations of such verbs. If any of ourassumptions on which the statements are based prove incorrect or shouldunanticipated circumstances arise, our actual results could materially differfrom those anticipated by such forward-looking statements. The differencescould be caused by a number of factors or combination of factors, including,but not limited to, the “Factors Affecting Operating Results” described hereinand the Risk Factors described in our Securities and Exchange Commissionfilings, including the Form 10-K filing for the year endedDecember 31, 2001.

 

*Overview*

 

We commencedoperations in October 1994. Through the end of 1996, we focused primarilyon research and development activities. Our first product was released inMarch 1997. In 1997 and 1998, we expanded our operations to capitalize onthe increased market demand for communications and interaction managementsoftware. We decided, at the expense of profitability, to continue investingsignificantly in research and development, and to accelerate our investments inmarketing, services and sales operations. We had no revenue in 1996, and ourtotal revenues were $1.6 million in 1997, $9.0 million in 1998,$19.1 million in 1999, $38.6 million in 2000, and $50.1 million in2001.   In the first quarter of 2002,our revenues were approximately $2.3 million less than in the first quarter of2001.  Accordingly, we cannot assure youthat our annual revenues will grow at such rates or at all in the future.

 

We believe ourinvestments in research and development and in marketing, services and salesoperations will continue to be critical to our revenue growth. However, theseinvestments have also significantly increased our operating costs and expenses,contributing to the net losses and operating losses that we have incurred ineach fiscal quarter since our formation. We anticipate that our operating costsand expenses will increase substantially for the foreseeable future as wecontinue to expand our research and development, marketing, services and salesoperations. Accordingly, we are likely to continue to experience losses and negativecash flows from operations in future quarters. We cannot assure you when or ifwe will achieve profitability or, if achieved, that we will be able to sustainprofitability. Our operating results have varied significantly from quarter toquarter and may continue to do so in the future. As a result, we believe thatperiod-to-period comparisons of our operating results are not necessarilymeaningful, and you should not rely on them as an indication of our futureperformance.

 

On April 4, 2002,we commenced a restructuring program to reduce expenses and improve efficiencydue to macro-economic and capital spending issues affecting our industry. This program included a worldwide workforce reduction, possible consolidationof excess facilities, and possible restructuring of certain businessagreements, functions, and relationships.  The restructuring programresulted in the reduction of approximately ten percent of the worldwideworkforce.  This reduction affected most business functions and geographicregions.  The restructuring is expected to be completed by the end of thesecond

 

8

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quarter of fiscal2002.  The financial impact of the restructuring and other special chargeswill be presented in the second quarter of fiscal 2002.

 

**Sourcesof Revenue and Revenue Recognition Policy**

 

We generate amajority of our revenues from software license fees. Most of our softwarelicense fees originate from the marketing efforts of our resellers, who areauthorized to place software orders with us on behalf of end-user customers. Weshare end-user customer software license fees with these resellers in varyingpercentages of our list price, according to the terms of their reselleragreements. In addition to generating software license fees indirectly throughresellers, we also receive some software license fees from end-user customersthat we deal with directly.

 

In accordance withAICPA Statement of Position (SOP) 97-2 as amended by SOP 98-4 and SOP 98-9,software license revenues can be recognized upon the shipment of software if:

 

• persuasive evidence of an arrangement exists,

• sufficient vendor-specific objective evidence existsto support allocating the total fee to all elements of the arrangement,

• the fee is fixed or determinable, and

• collection is probable.

 

As a result, wetypically recognize software license fees only when a reseller places a bindingorder for our software, which gives the reseller the right to distribute ourproducts to end-user customers. If the order includes an acceptance period, werecognize revenues upon the earlier of order acceptance or the expiration ofthe acceptance period.

 

We also generaterevenues from services that we provide to our resellers and end-user customers.Services revenues include product maintenance revenues, which consist oftechnical support and product upgrades, educational services and professionalservices. Our initial software license generally includes one year ofmaintenance. Generally, to continue using our software after this initialperiod, our end-user customers must purchase annual ongoing productmaintenance, which is priced at approximately 18% of the current list price ofthe licensed product. We share maintenance revenues with those resellers whoprovide first-level technical support according to the terms of their reselleragreements. When these revenues are shared with resellers, we typically receivebetween 50% and 70% of the amount charged to the end-user customer. Werecognize product maintenance revenues on a straight-line basis over the termof the initial software license and each subsequent annual product maintenancepurchase. Revenues from educational services, which consist of training coursesfor resellers and end-user customers, and professional services, which includeimplementing and customizing our products for an end-user customer, aretypically recognized as the related services are performed.

* *

*HistoricalResults of Operations*

 

The followingtable presents certain financial data, derived from our unaudited statements ofoperations, as a percentage of total revenues for the periods indicated. Theoperating results for the three months ended March 31, 2002 and 2001 are notnecessarily indicative of the results that may be expected for the full year orfor any future period.

 

9

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|                        |   | **Three  months ended  March 31,** |   |
|-----------------------------|--------|------------------------------------|--------|
|                        |   |                               |
|                        |   | **2002**                           |   | **2001** |   |
| Revenues:                   |   |                               |   |   |   |
| Software                    |   | 58                                 | %      | 70 | % |
| Services                    |   | 42                                 |   | 30 |   |
| Total revenues              |   | 100                                |   | 100 |   |
|                        |   |                               |   |   |   |
| Costs and  expenses:        |   |                               |   |   |   |
| Costs of  software          |   | 3                                  |   | 1 |   |
| Costs of  services          |   | 29                                 |   | 28 |   |
| Sales and  marketing        |   | 52                                 |   | 43 |   |
| Research and  development   |   | 38                                 |   | 31 |   |
| General and  administrative |   | 14                                 |   | 13 |   |
| Total costs and  expenses   |   | 136                                |   | 116 |   |
|                        |   |                               |   |   |   |
| Operating loss              |   | (36                                | )      | (16 | ) |
| Interest income,  net       |   | 1                                  |   | 3 |   |
| Loss before  income taxes   |   | (35                                | )      | (13 | ) |
| Income taxes                |   | 1                                  |   | 0 |   |
| Net loss                    |   | (36                                | )%     | (13 | )% |

 

*Revenues*

 

Our total revenuesdecreased 18% from $12.7 million for the three months ended March 31, 2001to $10.4 million for the three months ended March 31, 2002. Non-NorthAmerican revenues declined from $3.7 million for the three months endedMarch 31, 2001 to $1.6 million for the three months ended March 31, 2002.Our revenues are derived primarily from license fees and charges for services,including product maintenance, education services, and professional services.The decrease in total revenues resulted from lower software sales.  While it is difficult to project revenues inthe current economic environment, we anticipate software revenues will continueto represent the majority of our revenues for the foreseeable future.

* *

*Software.*  Our software revenuesdecreased 32% from $8.9 million for the three months ended March 31, 2001,to $6.0 million for the three months ended March 31, 2002. The decrease insoftware revenues resulted from a weak economic environment, particularly inthe technology markets, causing many of our customers to delay and/or reducetheir capital spending and related services.

* *

*Services.*  Services revenues increased16% from $3.8 million for the three months ended March 31, 2001, to$4.4 million for the three months ended March 31, 2002. The increase inservices revenues was primarily due to an increase in product maintenancerevenues, which is related to our growing installed base of end-user customers.

* *

*Costand Expenses*

 

Our total costs andexpenses decreased 3% from $14.6 million for the three months ended March31, 2001 to $14.2 million for the three months ended March 31, 2002. Thedecrease in amount was primarily due to the result of following theimplementation of our 2001 restructuring plan to reduce expenses, as well aslower revenues and increased operating efficiencies.

 

10

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*Costsof Software.*  Costsof software consist primarily of product royalties paid to third-parties forthe use of their technologies in our products and, to a lesser extent, softwarepackaging costs, which include product media, duplication and documentation.Costs of software increased from $149,000 for the three months ended March 31,2001 to $328,000 for the three months ended March 31, 2002. This representsapproximately 2% of software revenues for the three months ended March 31, 2001and 5% for the three months ended March 31, 2002. The dollar increase was dueto royalties owed as a result of additional licensing of third-party technologyassociated with the releases of our Interaction Center PlatformTM products andother related products. We expect product royalties to continue to increase aswe release additional products, release additional versions of our existingproducts, and integrate additional third-party software functions and featuresinto our product offerings.

* *

*Costsof Services.*  Costsof services consist primarily of compensation expenses for technical support,education, and professional services personnel and other costs associated withsupporting our resellers and end-user customers. Costs of services decreasedfrom $3.6 million for the three months ended March 31, 2001, to $3.0 millionfor the three months ended March 31, 2002. As a percentage of servicesrevenues, cost of services represented 95% and 69% for the three months endedMarch 31, 2001 and 2002, respectively. The dollar decrease is the result of areduction in employees and expenditures as part of our restructuring plans,lower outsourced services, as well as increased operating efficiencies

* *

*Salesand Marketing.*  Salesand marketing expenses consist of trade shows, advertising, telemarketingcampaigns, public relations and other promotional expenses, compensationexpenses, including sales commissions, and travel expenses. Sales and marketingexpenses remained constant  at$5.4 million for the three months ended March 31, 2001 and for thethree months ended March 31, 2002. As we continue to focus on sales growth anddevelop awareness for our products, we plan to continue investing significantlyin sales and marketing efforts.

* *

*Researchand Development.*  Researchand development expenses consist primarily of compensation expenses for ourdevelopers and third party efforts to develop and enhance our products,including adapting our products for specific non-English languages and allowingour products to effectively run with alternative hardware configurations.Research and development expenses remained constant at $3.9 million forthe three months ended March 31, 2001, and for the three months ended March 31,2002. Currently, all costs related to research and development of our productsare charged to research and development expense as incurred.

* *

*Generaland Administrative.  *General and administrative expenses consist primarilyof compensation for our administrative, financial, and information technologypersonnel, and a number of non-allocable costs, including legal and otherprofessional service fees. General and administrative expenses decreased from$1.6 million for the three months ended March 31, 2001, to $1.5 millionfor the three months ended March 31, 2002. The slight decrease was primarilydue to the savings from our 2001 reduction in force and cost containmentefforts.

* *

*Interestincome, net*

 

Interest income,net is generated primarily from invested funds from our initial public offeringcompleted in September 1999 and the equity investment made by CiscoSystems, Inc. (“Cisco”) in January 2001. Net interest income decreasedfrom $318,000 for the three months ended March 31, 2001 to $129,000 for thethree months ended March 31, 2002. This decrease can be attributed to thesubstantial decrease in interest rates and less invested cash.

* *

*Incometaxes*

 

For U.S. corporateincome tax purposes, we did not recognize a tax benefit related to U.S. federalor state income taxes during the three months ended March 31, 2001 or March 31,2002 because of the uncertainty of eventually realizing these benefits.However, we did recognize a tax expense related to our international operationsof $60,000 for the three months ended March 31, 2001, and $69,000 for the threemonths ended March 31, 2002.

 

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*Liquidityand Capital Resources*

 

As of March 31,2002, we had cash and cash equivalents of $2.4 million, $9.6 millionin short term investments, a working capital balance of $8.3 million, and$6.1 million in long-term investments, which consist of Federal AgencyNotes and U.S. Treasury Notes.

 

InSeptember 1999, we sold 3.0 million shares of common stock in ourinitial public offering, generating $39.0 million in cash, before offeringexpenses. Prior to our initial public offering, we funded our operationsprimarily through equity and debt infusions from our principal shareholder,Dr. Donald E. Brown, a $5.0 million equity investment by DialogicInvestment Corporation (formerly a subsidiary of Dialogic Corporation), andborrowings under commercial lines of credit.

 

OnJanuary 25, 2001 we received an equity investment from CiscoSystems, Inc. We sold 515,517 shares of common stock at a price of $29.00per share, yielding approximately $15.0 million in cash.

 

Our operatingactivities resulted in net cash outflows of $3.2 million for the threemonths period ended March 31, 2002, and a cash inflow of $2.6 million forthe three months period ended March 31, 2001. The net operating cash outflowfor the first three months of 2002 was primarily the result of our operatingloss and an increase in accounts receivable, partially offset by the non-cashdepreciation amount. The net operating cash inflow for the first three monthsof 2001 was primarily the result of an increase in deferred revenue, a decreasein accounts receivable, offset by our operating loss and increases in non-cashdepreciation and accounts payable.

 

Our investingactivities have consisted primarily of capital expenditures for property andequipment and purchases and sales of investments. Our activities resulted in a$9.1 million outflow for the three months period ended March 31, 2002 and a$9.9 million outflow for the three months period ended March 31, 2001. Theoutflow for the first three months of 2001 and 2002 was attributed to net purchasesof available-for-sale investments and capital expenditures for property andequipment. At March 31, 2002, we did not have any material commitments forfuture capital expenditures.

 

In April 2001, weentered into a non-cancelable lease agreement for a new, approximately 120,000square foot corporate headquarters building with a targeted occupation date ofApril 2003.  Over the life of the lease,we are committed to expend approximately $35.0 million in rent payments.

 

For the threemonths period ended March 31, 2002 we generated $167,000 from financingactivities attributed to the issuance of common stock and stock optionexercises.

 

At March 31, 2002,we had no amounts outstanding on our line of credit and were in compliance withall related covenants and restrictions. This line of credit expires on June 22, 2002.

 

We believe thatour existing cash and cash equivalents and short-term investments will besufficient to meet our working capital and capital expenditure requirements forat least the next 12 months. After that time, we may require additionalfunds to support our working capital requirements or for other corporatepurposes, and we may seek to raise additional funds through public or privateequity or debt financings or from other sources. We cannot assure you thatadditional financing will be available at all or that, if available, it will beon terms favorable to us or that any additional financing will not dilute yourownership interest in Interactive Intelligence.

 

*FactorsAffecting Operating Results*

 

**OURLIMITED OPERATING HISTORY MAKES FINANCIAL FORECASTING DIFFICULT AND, IN****ASSESSINGOUR PROSPECTS, YOU SHOULD CONSIDER OUR EARLY STAGE OF DEVELOPMENT AND****PRESENCEIN A NEW AND RAPIDLY EVOLVING INDUSTRY**

 

Our limitedoperating history makes it difficult to forecast our future operating results.We commenced operations in October 1994, but did not begin shipping anInteraction Center Platformä-based product until 1997.  In 1999, we began shipping InteractionRecorderâ, Interaction DialerTM, and e-FAQTM.Accordingly, you should assess our prospects in light of the risks anddifficulties frequently encountered by

 

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companies in the earlystage of development, particularly companies in new and rapidly evolvingindustries.

 

**WEHAVE HISTORICALLY INCURRED LOSSES AND WE MAY NOT ACHIEVE PROFITABILITY**

 

We have notoperated profitably to date. We incurred net losses of $9.0 million, $4.6million, and $7.1 million in 2001, 2000, and 1999, respectively. At March 31,2002, we had accumulated losses since inception of $39.1 million. We intend tocontinue to make significant investments in our research and development,marketing, services and sales operations. We anticipate that these expensescould significantly precede any revenues generated by the increased spending.As a result, we are likely to continue to experience losses and negative cashflow from operations in future quarters. If we do become profitable, we may notsustain or increase our profitability.

 

**OURQUARTERLY OPERATING RESULTS HAVE VARIED SIGNIFICANTLY AND, IF SEVERAL****FACTORSAFFECTING OUR BUSINESS CAUSE THEM TO CONTINUE TO DO SO, THE MARKET PRICE OF OURCOMMON STOCK COULD BE AFFECTED**

 

Our operatingresults have varied significantly from quarter to quarter and may continue todo so in the future depending on a number of factors affecting us or ourindustry, including many that are beyond our control. As a result, we believethat period-to-period comparisons of our operating results are not necessarilymeaningful, and you should not rely on them as an indication of our futureperformance. In addition, our operating results in a future quarter or quartersmay fall below expectations of securities analysts or investors and, as aresult, the price of our common stock may fluctuate.

 

Because we do notknow when our potential end-user customers will place orders and finalizecontracts, we cannot accurately forecast our revenues and operating results forfuture quarters. We recognize revenues on satisfaction of the requirements ofAICPA Statement of Position 97-2, which generally occurs in the same quarterthat the order is received. As a result, our quarterly revenues and operatingresults depend primarily on the size, quantity and timing of orders receivedfor our products during each quarter. If a large number of orders or severallarge orders do not occur or are deferred or delayed, our revenues in a quartercould be substantially reduced. This risk is heightened by the significantinvestment and executive level decision making typically involved in ourend-user customers’ decisions to license our products. Since a large portion ofour operating expenses, including rent and salaries, is fixed and difficult toreduce or modify, our business, financial condition or results of operationscould be materially adversely affected if revenues do not meet ourexpectations.

 

Because of ourearly stage of development and limited number of products, changes in pricingpolicies and the timing of the development, announcement and sale of new orupgraded versions of our products are some of the additional factors that couldcause our 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 QUARTER-TO-QUARTER VARIABILITY OF OUR REVENUES AND****OPERATINGRESULTS, WHICH COULD AFFECT THE MARKET PRICE OF OUR COMMON STOCK**

 

We have generallyexperienced a lengthy product sales cycle, averaging approximately six to ninemonths. The lengthy sales cycle is one of the factors that has caused, and mayin the future continue to cause, our software revenues and operating results tovary significantly from quarter to quarter, which could affect the market priceof our common stock. It also makes it difficult for us to forecast productlicense revenues. Because of the unique characteristics of our products, ourprospective end-user customers’ decisions to license our products often requiresignificant investment and executive level decision making. We believe thatmany companies currently are not aware of the benefits of interactionmanagement software of the type we license or of our products and capabilities.For this reason, we must provide a significant level of education toprospective end-user customers about the use and benefits of our products,

 

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which can cause potentialend-user customers to take many months to make these decisions. As a result,sales cycles for end-user customer orders vary substantially from customer tocustomer. Excessive delay in product sales could materially adversely affectour business, financial condition or results of operations.

 

The length of thesales cycle for end-user customer orders depends on a number of other factorsover which we have little or no control, including:

 

•      an end-user customer’s budgetaryconstraints;

 

•      the timing of an end-usercustomer’s budget cycles;

 

•     concerns by end-usercustomers about the introduction of new products by us or our competitors; and

 

•      downturns in generaleconomic conditions, including reductions in demand for call center services.

 

In addition, the sales cycle for our products ininternational markets has been, and is expected to continue to be, longer thanthe sales cycle in the United States. The average sales cycle for our productsmay lengthen as we expand internationally.

 

**OURINABILITY TO MANAGE SUCCESSFULLY OUR INCREASINGLY COMPLEX****THIRD PARTYRELATIONSHIPS COULD ADVERSELY AFFECT US**

 

As the complexityof our product technology and our reseller and other third-party relationshipshave increased, the management of those relationships and the negotiation ofcontractual terms sufficient to protect our rights and limit our potentialliabilities has become more complicated, and we expect this trend to continuein the future. As a result, our inability to successfully manage theserelationships or negotiate sufficient contractual terms could have a materialadverse effect on us.

 

**WEFACE COMPETITIVE PRESSURES, WHICH MAY HAVE A MATERIAL ADVERSE EFFECT ON US**

 

The market for oursoftware products is highly competitive and, because there are relatively lowbarriers to entry in the software market, we expect competition to increasesignificantly in the future. In addition, because our industry is new andevolving and characterized by rapid technological change, it is difficult forus 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 andtelecommunications equipment vendors. We cannot assure you that we will be ableto compete effectively against current and future competitors. In addition,increased competition or other competitive pressures may result in pricereductions, reduced margins or loss of market share, any of which could have amaterial adverse effect on our business, financial condition or results ofoperations.

 

Many of ourcurrent and potential competitors have longer operating histories,significantly greater financial, technical, marketing, customer service andother resources, greater name recognition and a larger installed base ofcustomers than we do. As a result, these competitors may be able to respond tonew or emerging technologies and changes in customer requirements faster andmore 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 end-user customers. If these competitors were toacquire significant market share, it could have a material adverse effect onour business, financial condition or results of operations.

 

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**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 toachieve revenue growth in the future will depend in part on our success inmaintaining successful relationships with our existing and future resellers andOEM partners and in recruiting and training additional resellers and OEMpartners. We rely primarily on resellers to market and support our products,and plan on relying more on our OEM partners in the future. We are stilldeveloping and refining 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 resellersor OEM partners or a significant number of resellers or OEM partners couldmaterially adversely affect our business, financial condition or results ofoperations.

 

**OURMARKETS ARE CHARACTERIZED BY RAPID TECHNOLOGICAL CHANGE WHICH MAY CAUSE US****TO INCURSIGNIFICANT DEVELOPMENT COSTS AND PREVENT US FROM ATTRACTING NEW****CUSTOMERS**

 

The market for ourproducts is characterized by rapid technological change, frequent new productintroductions and enhancements, uncertain product life cycles and changingend-user customer demands. The introduction of products embodying newtechnologies and the emergence of new industry standards could render existingproducts obsolete or unmarketable and cause us to incur significant developmentcosts.

 

**THE GROWTH OF OUR BUSINESS MAY BEIMPEDED WITHOUT INCREASED USE OF THE INTERNET**

 

The use of theInternet as a commercial marketplace is at an early stage of development. Demandand market acceptance for recently introduced products and services availableover the Internet are still uncertain. In addition, governmental regulation ofthe Internet, such as imposing sales and other taxes, access charges, andpricing controls and inhibiting cross–border commerce, may reduce the useof the Internet by businesses for their electronic commerce and customerservice needs. To date, governmental regulations have not materially restrictedcommercial use of the Internet. However, the legal and regulatory environmentthat pertains to the Internet is uncertain and may change. New regulationscould reduce the use of the Internet by our end–user customers and, inturn, their customers. The lack of acceptance of the Internet as a forum forconducting business could reduce growth in demand for our products and limitthe growth of our revenue.

 

**OUR BUSINESS WILL BE ADVERSELYAFFECTED IF WEB-BASED ELECTRONIC BUSINESS SOLUTIONS ARE NOT WIDELY ADOPTED**

 

Our productsaddress a new and emerging 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 develop, 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 andtaxation of Internet commerce.

 

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**ADECLINE IN MARKET ACCEPTANCE FOR MICROSOFT CORPORATION TECHNOLOGIES ON WHICH****OURPRODUCTS RELY COULD HAVE A MATERIAL ADVERSE EFFECT ON US**

 

Our productscurrently run only on Microsoft Windows 2000® servers. In addition, ourproducts use other Microsoft Corporation 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 thatour future business prospects depend in large part on our ability to maintainand improve our current products and to develop new products on a timely basis.Our products will have to achieve market acceptance, maintain technologicalcompetitiveness and meet an expanding range of end-user customer requirements.As a result of the complexities inherent in our products, major new productsand product enhancements require long development and testing periods. We maynot be successful in developing and marketing, on a timely and cost effectivebasis, product enhancements or new products that respond to technologicalchange, evolving industry standards or end-user customer requirements. We mayalso experience difficulties that could delay or prevent the successfuldevelopment, introduction or marketing of product enhancements, and our newproducts and product enhancements may not achieve market acceptance. Significantdelays in the general availability of new releases of our products orsignificant problems in the installation or implementation of new releases ofour products could have a material adverse effect on our business, financialcondition or results of operations.

 

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

 

If the demand forinteraction management software of the type we license does not grow withineach of our three targeted markets, our ability to grow our business could bematerially adversely affected. All of our revenues have been generated fromlicenses of our Interaction Center Platformäsoftware or complementary products, and related support, educational andprofessional services. We expect these products and services to account for themajority of our revenues for the foreseeable future. Although we believe demandfor the functions performed by our products is high, the market for our productsand services is still emerging. Further, our growth plans require us tosuccessfully attract enterprise and service provider end-user customers.

 

**IF OUR END-USER CUSTOMERS DO NOTPERCEIVE OUR PRODUCTS OR THE RELATED SERVICES PROVIDED BY US OR OUR RESELLERSOR OEM PARTNERS TO BE EFFECTIVE OR OF HIGH QUALITY, OUR BRAND AND NAMERECOGNITION WILL SUFFER**

 

We believe thatestablishing and maintaining brand and name recognition is critical forattracting, retaining and expanding end–user 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 end–user customers donot perceive our products or related services to be effective or of highquality, our brand and name recognition would suffer which could have amaterial adverse effect on our business, financial condition or results ofoperations.

 

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**IFWE ARE UNABLE TO ADAPT OUR SOFTWARE IN A WAY THAT WILL PERMIT US TO SERVE****LARGE,SINGLE-SITE END-USER CUSTOMERS, THE MARKETABILITY OF OUR PRODUCTS COULD BE****ADVERSELYAFFECTED**

 

Our productscannot currently meet the communications needs of organizations with more than500 users at a single call center location and cannot currently meet the communicationneeds of organizations with more than 1,000 users at a single enterpriselocation. As these organizations expand to include multiple locations, ourproducts can be customized to increase the number of telephone lines,extensions and users. We will need to adapt our software to serve larger single–siteorganizations.  Although we arecurrently developing and testing solutions that would enable our software tosignificantly increase the number of users that our products can serve at asingle location, we cannot assure you that we will be able to successfullyintroduce this technology into a currently available version of ourproducts.  Further, we may not be ableto adapt our software in a timely or cost effective manner in a way that willpermit us to serve these customers. This inability could have a materialadverse effect on our business, financial condition or results of operations.

 

**OUR MAINSUPPLIERS OF VOICE PROCESSING BOARDS MAY BECOME UNWILLING OR UNABLE TO CONTINUETO MANUFACTURE AND SUPPLY US WITH VOICE PROCESSING BOARDS, REQUIRING US TOINTRODUCE A SUBSTITUTE SUPPLIER WHICH COULD PROVE DIFFICULT OR COSTLY**

 

Dialogic Corporation andAcuLab plc are our primary suppliers of the voice processing boards that areused by a majority of our end-user customers for the operation of ourproducts.  If a majority of futureend-user customers desire to utilize the voice processing boards to enable ourproducts and these suppliers become unable or unwilling to continue tomanufacture and supply these voice processing boards in the volume, price andtechnical specifications we require, then we would have to adapt our productsto a substitute supplier.  We may not beable to successfully introduce voice processing boards made by a substitutesupplier into the available versions of our products. In addition, introducinga substitute supplier of voice processing boards could result in unforeseenadditional product development or customization costs and could also introducehardware and software operating or compatibility problems. We cannot assure youthat these issues will not affect product shipments, will not be costly tocorrect, will not damage our reputation in the markets in which we operate, orwill not have a material adverse affect on our business, financial condition orresults of operations.

 

In addition, Dialogic Corporation’sCT MediaTM  server software offers someof the functionality that our Interaction Center Platformäproducts provide and consequently could make it easier for competitors orpotential competitors to provide products competitive with ours. If CT MediaTMwere to become an industry standard, our failure to adopt it could disadvantageus in competitive situations.  Inaddition, although neither of our primary suppliers of voice processing boardsnor their affiliates currently offer a product that competes with ourInteraction Center Platformä products, theycould potentially develop a competitive or superior product.

 

**WEMAY NOT BE ABLE TO PROTECT OUR PROPRIETARY RIGHTS ADEQUATELY, WHICH COULD****ALLOWTHIRD PARTIES TO COPY OR OTHERWISE OBTAIN AND USE OUR TECHNOLOGY WITHOUT****AUTHORIZATION**

 

We regard oursoftware products as proprietary. In an effort to protect our proprietaryrights, we rely primarily on a combination of copyright, trademark and tradesecret laws, as well as licensing and other agreements with consultants,suppliers, strategic and OEM partners, resellers and end–user customers,and employee and third–party non–disclosure agreements. These lawsand agreements provide only limited protection of our proprietary rights. Inaddition, we have not signed agreements containing these types of protectiveprovisions in every case, and the contractual provisions that are in place andthe protection they provide vary and may not provide us with adequateprotection in all circumstances. Although we have filed patent applicationsdirected to several inventions embodied in our software products, we currentlyhold no patents. We hold seven U.S.trademark registrations and 12 foreign trademark registrations, and have

 

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numerous other trademark applications pending worldwide, as well ashaving common law rights in other trademarks and service marks.  We hold one registered copyright.Because our means of protecting our proprietary rights may not be adequate, itmay 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 licensetechnology that is embedded in our products from others. If one or more ofthese licenses terminates or cannot be renewed on satisfactory terms, we wouldhave to modify the affected products to use alternative technology or eliminatethe affected product function, either of which could have a material adverseeffect on us.

** **

**INFRINGEMENTCLAIMS COULD ADVERSELY AFFECT US**

 

In June 1999 andSeptember 1999, we received letters from a competitor in the call center marketclaiming that our products utilize technologies pioneered and patented by thatcompetitor.  Our patent counsel hasreviewed all of the patents listed in the letters.  Based on the advice of our patent counsel, we believe that ourproducts do not infringe any of the patents listed in either letter.  We have discussed our conclusion with thecompetitor and have also discussed possible licensing of certain technologiesfrom the competitor.  We cannot assureyou that this matter can be resolved amicably without litigation, or that wewill ultimately be able to enter into a licensing arrangement on terms andconditions that would not have a material adverse effect on our business,financial condition or results of operations.

 

In June 2000 andOctober 2001, we received letters from a competitor in the outbound call centermarket claiming that our products utilize technologies pioneered and patentedby the competitor.  Although our patentcounsel has not determined the validity of these patents, we have discussed thepossible licensing of certain technologies from the competitor.  We cannot assure you that these claims canbe resolved amicably without litigation, or that we will be able to enter intolicensing arrangements on terms and conditions that would not have a materialadverse effect on our business, financial condition or results of operations.

 

In July 2000, we receiveda letter from Avaya, Inc., a competitor in the call center market, claimingthat our products utilize technologies pioneered and patented by them.  As a result of subsequent discussions, weaccrued an appropriate amount for the licensing of certain technologies relatedto 2001 and prior years in the financial statements for the year ended December31, 2001.  An agreement was finalizedand executed in February 2002 and we believe the terms and conditions of thelicensing arrangement will not have a material adverse effect on our business,financial condition or results of operations.

 

Other third parties couldclaim that our technology infringes their proprietary rights. As the number ofsoftware products in our target markets increases and the functionality ofthese products overlap, we believe that software developers may faceinfringement claims. For example, various patent rights have been assertedagainst interfaces between PBX hardware and computer network systems. Althoughwe believe that our products do not infringe any of these patents because,among other reasons, our products are designed to replace PBXs and not tocreate such interfaces, if these patents were interpreted broadly, claims ofinfringement of these patents could have a material adverse affect on us.

 

Infringementclaims, even if without merit, can be time consuming and expensive to defend. Athird party asserting infringement claims against us or our customers withrespect to our current or future products may require us to enter into costlyroyalty arrangements or litigation, or otherwise materially adversely affectus.

 

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**WEDEPEND ON KEY PERSONNEL AND WILL NEED TO RECRUIT ADDITIONAL SKILLED****PERSONNEL,FOR WHICH COMPETITION IS INTENSE, TO CONDUCT AND GROW OUR BUSINESS****EFFECTIVELY**

 

Our successdepends in large part on the continued service of our key personnel,particularly Dr. Donald E. Brown, our Chief Executive Officer andprincipal stockholder, and Dr. Michael D. Gagle, our Chief Scientist. Theloss of the services of either of these individuals or any key personnel couldhave a material adverse effect on our business, financial condition or resultsof operations.  We do not have key manlife insurance on any of our employees. Our future success also depends on our ability to attract, train,assimilate and retain additional qualified personnel. Competition for personswith skills in the software industry is intense, particularly for those withrelevant technical and/or sales experience. We cannot assure you that we willbe able to retain our key employees or that we can attract, train, assimilateor retain other highly qualified personnel in the future.

 

**OUR WORKFORCE REDUCTION AND FINANCIALPERFORMANCE MAY ADVERSELY AFFECT THE MORALE AND PERFORMANCE OF OUR PERSONNELAND OUR ABILITY TO HIRE NEW PERSONNEL**

 

In connection withour effort to streamline operations, reduce costs and rationalize our staffingand structure, we had a reduction in both 2001 and April 2002 of our worldwideworkforce of approximately ten percent each. There were and may continue to be substantial costs associated with theworkforce reductions related to severance and other employee-related  costs, and our restructuring plans may stillyield unanticipated consequences, such as attrition beyond our implementedreduction in workforce.  As a result,our ability to respond to unexpected challenges may be impaired and we may beunable to take advantage of new opportunities. The reduction in workforce mayreduce employee morale and may create concern among existing employees aboutjob security, which may lead to increased turnover.  These reductions in headcount may still subject us to the risk oflitigation.  In addition, recent tradinglevels of our common stock have decreased the value of the stock optionsgranted to employees pursuant to our stock option plans.  As a result of these factors, our remainingpersonnel may seek employment with larger, more established companies orcompanies they perceive as having less volatile stock prices.

 

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

 

In the future wemay pursue additional acquisitions to diversify our product offerings andcustomer base or for other strategic purposes. We have no prior history ofmaking material acquisitions and we cannot assure you that any futureacquisitions will be successful. The following are some of the risks associatedwith acquisitions that could have a material adverse effect on our business,financial condition or results of operations:

 

•               Wecannot assure that any acquired businesses will achieve anticipated revenues,earnings or cash flow.

 

•               Wemay be unable to integrate acquired businesses successfully and realizeanticipated economic, operational and other benefits in a timely manner,particularly if we acquire a business in a market in which we have limited orno current expertise, or with a corporate culture different from our own. If weare unable to integrate acquired businesses successfully, we could incursubstantial costs and delays or other operational, technical or financialproblems.

 

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

 

•               Wemay finance future acquisitions by issuing common stock for some or all of thepurchase price. This could dilute the ownership interests of our stockholders.We may also incur additional debt or be required to recognize amortizationexpense related to goodwill and other intangible assets purchased in futureacquisitions.

 

•               Wewould be competing with other firms, many of which have greater financial andother resources, to acquire attractive companies. We believe this competitionwill increase, making it more difficult to acquire suitable companies onacceptable terms.

 

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**OURINTERNATIONAL OPERATIONS AND EXPANSION INVOLVE FINANCIAL AND OPERATIONAL****RISKS**

 

The expansion ofour international operations will require significant management attention andfinancial resources to establish additional foreign operations, hire additionalpersonnel and recruit additional international resellers. Non-North Americanrevenues accounted for 21%, 25%, and 19% of our total revenues in 2001, 2000,and 1999, respectively. To date, our products have been licensed outside NorthAmerica primarily in Western Europe, South Africa, and Australia. We are alsoexpanding our marketing efforts in Japan, Korea, China and Central and SouthAmerica. We intend to continue to expand our international operations and enteradditional international markets. Revenues from international expansion may beinadequate to cover the expenses of international expansion. In addition toforeign currency fluctuation risks described in the next risk factor, otherrisks inherent in our international business activities, in the countries inwhich we have licensed our products to date and in those countries in which weintend to expand, generally could include the following:

 

•               economicand political instability;

 

•               unexpectedchanges in foreign regulatory requirements and laws;

 

•               tariffsand other 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;

 

•               lackof acceptance of our products in foreign countries;

 

•               longersales cycles and accounts receivable payment cycles;

 

•               potentiallyadverse tax consequences; and

 

•               restrictionson the repatriation of funds.

 

**FLUCTUATIONS IN THE VALUE OF FOREIGN CURRENCIES COULD RESULT IN LOSSES**

 

Our internationalrevenues are generally denominated in U.S. Dollars, but 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****DELAY INACCEPTANCE OF OUR PRODUCTS IN THE MARKET**

 

Our products,including components supplied by others, may contain errors or defects,especially when first introduced or when new versions are released. Despiteinternal product testing, we have in the past discovered software errors insome of our products after their introduction. Errors in new products orreleases could be found after commencement of commercial shipments, and thiscould result in additional development costs, diversion of technical and otherresources from our other development efforts, or the loss of credibility withcurrent or future end-user customers. This could result in a loss of revenue ordelay in market acceptance of our products, which could have a material adverseeffect on our business, financial condition or results of operations.

 

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Our license agreements with our end-user customerstypically contain provisions designed to limit our exposure to potentialproduct liability and some contract claims. However, not all of theseagreements contain these types of provisions and, where present, theseprovisions vary as to their terms and may not be effective under the laws ofsome jurisdictions. A product liability, warranty, or other claim broughtagainst us could have a material adverse effect on our business, financialcondition or results of operations.

 

Because our solution currently consists of oursoftware running on a Windows NT® server and voice processing boards, it isinherently more prone to performance interruptions for our end-user customersthan traditional non-software based products. Performance interruptions at ourend-user customer sites, most of which currently do not have back-up systems,could affect demand for our products or give rise to claims against us.

 

From time to time, we are also involved in certainlegal proceedings in the ordinary course of conducting our business. While theultimate liability, if any, in these actions cannot currently be determined, webelieve these legal proceedings will not have a material adverse effect on ourfinancial position.

 

**WEMAY NOT BE ABLE TO OBTAIN ADEQUATE FINANCING TO IMPLEMENT OUR STRATEGY**

 

Successfulimplementation of our strategy may require continued access to capital. If wedo not generate sufficient cash from operations, our growth could be limitedunless we are able to obtain capital through additional debt or equityfinancings. We cannot assure you that debt or equity financings will beavailable as required for acquisitions or other needs. Even if financing isavailable, it may not be on terms that are favorable to us or sufficient forour needs. If we are unable to obtain sufficient financing, we may be unable tofully implement our growth strategy.

** **

**OUR STOCK PRICE HAS BEEN AND COULD CONTINUE TO BE HIGHLY VOLATILE**

 

Our stock pricehas been and could continue to be highly volatile due to a number of factors,including:

 

•        actual or anticipated fluctuations inour operating results;

 

•        announcements by us, our competitors orour end–user customers;

 

•                        changes in financial estimatesof securities analysts or investors regarding us, our industry, our competitorsor our end–user customers;

 

•        technological innovations by others;

 

•                        the operating and stock priceperformance of other comparable companies or of our competitors or end–usercustomers;

 

•        the low number of our shares typicallytraded in any trading session;

 

•                        the availability for futuresale, or sales, of a substantial number of shares of our common stock in thepublic market; and

 

•        general market or 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.

 

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In addition, thestock market has experienced significant price and volume fluctuations thathave particularly affected the trading prices of equity securities of manytechnology companies, including us. These price and volume fluctuations oftenhave been unrelated to the operating performance of the affected companies. Inthe past, following periods of volatility in the market price of a company’ssecurities, securities class action litigation has often been institutedagainst that company. This type of litigation, regardless of the outcome, couldresult in substantial costs and a diversion of management’s attention andresources, which could materially and adversely affect our business, financialcondition or results of operations.

 

**Item 3. Quantitative and Qualitative Disclosures about MarketRisk.**

 

We develop products in the United States and selllicenses in North America, Europe, the Asia/Pacific region, South Africa, andCentral and South America. As a result, our financial results could be affectedby various factors, including changes in foreign currency exchange rates orweak economic conditions in foreign markets. As most sales are currently madein U.S. dollars, a strengthening of the dollar could make our products lesscompetitive in foreign markets. Additionally, as our business matures in foreign markets, we may offerour products and services in certain local currencies.  As a result, we will be subject to foreigncurrency fluctuations which may have an adverse affect on the company.

 

We manage our interest rate risk by maintaining aninvestment portfolio with debt instruments of high credit quality andrelatively short average maturities. We also manage interest rate risk bymaintaining sufficient cash and cash equivalent balances such that we aretypically able to hold our investments to maturity.

 

**P**ARTII. OTHER INFORMATION

 

**Item1. Legal Proceedings.**

 

See Note 4 of our Notes to the Condensed ConsolidatedFinancial Statements for a description of correspondence received by us fromcompetitors claiming that our products utilize technologies pioneered andpatented by them.

 

From time to time, we are also involved in certainlegal proceedings in the ordinary course of conducting our business. While theultimate liability, if any, in these actions cannot currently be determined, webelieve these legal proceedings will not have a material adverse effect on ourfinancial position. 

 

**Item6. Exhibits and Reports on Form 8-K.**

 

(a)          Exhibits

None.

 

(b)         Reports on Form 8-K

No reports on Form 8-Kwere filed during the quarter covered by this Form 10-Q.

 

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**SIGNATURES**

 

Pursuant to the requirements of the SecuritiesExchange Act of 1934, the Registrant has duly caused this report to be signedon its behalf by the undersigned thereunto duly authorized.

 
|               |   | Interactive Intelligence, Inc.                                  |
|--------------------|--------|-----------------------------------------------------------------|
|               |   | (Registrant)                                                    |
|               |   |                                                            |
| Date: May 13, 2002 |   | By  /s/ Keith  A. Midkiff                                  |   |
|               |   |                                                            |
|               |   | Keith A. Midkiff                                                |
|               |   | Chief Financial Officer, Secretary and Treasurer                |
|               |   | (Principal Financial Officer and Principal  Accounting Officer) |

 

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