**UNITED
      STATES**


**SECURITIES
      AND EXCHANGE COMMISSION**


**Washington,
      D.C. 20549**





**____________**





**FORM
      10-Q**


**____________**





**(Mark
      One)**





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





**For
      the quarterly period ended September 30, 2007**





**Or**





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





**For
      the transition period from ____________to____________**





**Commission
      File Number: 000-27385**







**INTERACTIVE
      INTELLIGENCE, INC.**


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





**Indiana**
              (State
                or other jurisdiction
              of
                incorporation or organization)
            
            **35-1933097**
              (I.R.S.
                Employer Identification No.)**7601
                Interactive Way**
              **Indianapolis,
                IN 46278**
              (Address
                of principal executive offices, including zip code)**(317)
                872-3000**
              (Registrant’s
                telephone number, including area code)





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




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




Large
                accelerated filer
            *****
            Accelerated
                filer
            **R**
            Non
                accelerated filer
            *****





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





As
      of
      October 31, 2007, there were 17,632,211 shares outstanding of the registrant’s
      common stock, $0.01 par value.
























TABLE
      OF CONTENTS




PART
                  I. FINANCIAL INFORMATION
              **Page**Item
                  1.
              Financial
                  Statements.Condensed
                  Consolidated Balance Sheets as of September 30, 2007 and December
                  31,
                  2006
              3Condensed
                  Consolidated Statements of Income for the Three and Nine Months
                  Ended
                  September 30, 2007 and 2006
              4Condensed
                  Consolidated Statement of Shareholders’ Equity for the Nine Months Ended
                  September 30, 2007
              5Condensed
                  Consolidated Statements of Cash Flows for the Nine Months Ended
                  September
                  30, 2007 and 2006
              6Notes
                  to Condensed Consolidated Financial Statements
              7Item
                  2.
              Management’s
                  Discussion and Analysis of Financial Condition and Results of
                  Operations.
              15Item
                  3.
              Quantitative
                  and Qualitative Disclosures About Market Risk.
              25Item
                  4.
              Controls
                  and Procedures.
              25PART
                  II. OTHER INFORMATIONItem
                  1.
              Legal
                  Proceedings.
              25Item
                  1A.
              Risk
                  Factors.
              25Item
                  6.
              Exhibits.
              26SIGNATURES
              27







-
            2
            -




**PART
      I. FINANCIAL INFORMATION**





**Item
      1. Condensed Consolidated Financial Statements and Notes to Condensed
      Consolidated Financial Statements.**





**Interactive
      Intelligence, Inc.**


**Condensed
      Consolidated Balance Sheets**


**As
      of September 30, 2007 and December 31, 2006**


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





**September
                  30,**
                **2007**
            
            
            **December
                  31,**
                **2006****(unaudited)**
            
            
            **(Note
                1)****Assets**Current
                assets:Cash
                and cash equivalents
            
            $
            23,430
            
            
            $
            13,531Short-term
                investments
            
            
            10,949
            
            
            
            13,555Accounts
                receivable, net of allowance for doubtful accounts of $776 at September
                30, 2007
              and
                $596 at December 31, 2006
            
            
            29,561
            
            
            
            21,370Deferred
                tax assets, net
            
            
            1,314
            
            
            
            1,314Prepaid
                expenses
            
            
            6,057
            
            
            
            5,358Other
                current assets
            
            
            1,602
            
            
            
            1,818Total
                current assets
            
            
            72,913
            
            
            
            56,946Property
                and equipment, net
            
            
            7,165
            
            
            
            5,469Deferred
                tax assets, net
            
            
            3,686
            
            
            
            3,686Other
                assets, net
            
            
            1,769
            
            
            
            674Total
                assets
            
            $
            85,533
            
            
            $
            66,775**Liabilities
                and Shareholders’ Equity**Current
                liabilities:Accounts
                payable and accrued liabilities
            
            $
            9,077
            
            
            $
            7,885Accrued
                compensation and related expenses
            
            
            4,487
            
            
            
            3,825Deferred
                product revenues
            
            
            6,818
            
            
            
            5,910Deferred
                services revenues
            
            
            30,352
            
            
            
            24,877Total
                current liabilities
            
            
            50,734
            
            
            
            42,497Commitments
                and contingencies
            
            
            --
            
            
            
            --Shareholders’
                equity:Preferred
                stock, no par value: 10,000,000 shares authorized; no shares issued
                and
                outstanding
            
            
            --
            
            
            
            --Common
                stock, $0.01 par value: 100,000,000 shares authorized; 17,534,947
                issued
                and outstanding
              at
                September 30, 2007 and 17,139,804 issued and outstanding at December
                31,
                2006
            
            
            175
            
            
            
            171Additional
                paid-in capital
            
            
            76,588
            
            
            
            72,528Accumulated
                deficit
            
            
            (41,964
            )
            
            
            (48,421
            )Total
                shareholders’ equity
            
            
            34,799
            
            
            
            24,278Total
                liabilities and shareholders’ equity
            
            $
            85,533
            
            
            $
            66,775







*See
      Accompanying Notes to Condensed Consolidated Financial
      Statements*





-
            3
            -




**Interactive
        Intelligence, Inc.**
 **Condensed
        Consolidated Statements of Income (unaudited)**
 **For
        the Three and Nine Months Ended September 30, 2007 and
        2006**
 **(In
        thousands, except per share amounts)**
 
 **Three
                    Months Ended**
                  **September
                    30,**
              
              
              **Nine
                    Months Ended**
                  **September
                    30,****2007**
              
              
              **2006**
              
              
              **2007**
              
              
              **2006****Revenues:**Product
              
              $
              15,032
              
              
              $
              11,967
              
              
              $
              41,740
              
              
              $
              30,414Services
              
              
              13,676
              
              
              
              10,030
              
              
              
              38,141
              
              
              
              28,766Total
                  revenues
              
              
              28,708
              
              
              
              21,997
              
              
              
              79,881
              
              
              
              59,180**Cost
                  of revenues:**Product
              
              
              4,232
              
              
              
              2,707
              
              
              
              10,173
              
              
              
              6,073Services
              
              
              5,533
              
              
              
              3,828
              
              
              
              15,475
              
              
              
              10,121Total
                  cost of revenues
              
              
              9,765
              
              
              
              6,535
              
              
              
              25,648
              
              
              
              16,194Gross
                  profit
              
              
              18,943
              
              
              
              15,462
              
              
              
              54,233
              
              
              
              42,986**Operating
                  expenses:**Sales
                  and marketing
              
              
              9,231
              
              
              
              7,535
              
              
              
              26,680
              
              
              
              21,283Research
                  and development
              
              
              4,348
              
              
              
              3,519
              
              
              
              12,472
              
              
              
              9,933General
                  and administrative
              
              
              3,310
              
              
              
              2,739
              
              
              
              9,660
              
              
              
              8,106Total
                  operating expenses
              
              
              16,889
              
              
              
              13,793
              
              
              
              48,812
              
              
              
              39,322Operating
                  income
              
              
              2,054
              
              
              
              1,669
              
              
              
              5,421
              
              
              
              3,664**Other
                  income (expense):**Interest
                  income, net
              
              
              412
              
              
              
              162
              
              
              
              1,268
              
              
              
              382Other
                  income (expense), net
              
              
              29
              
              
              
              (25
              )
              
              
              (69
              )
              
              
              (89
              )Total
                  other income, net
              
              
              441
              
              
              
              137
              
              
              
              1,199
              
              
              
              293Income
                  before income taxes
              
              
              2,495
              
              
              
              1,806
              
              
              
              6,620
              
              
              
              3,957Income
                  tax benefit (expense)
              
              
              37
              
              
              
              4,912
              
              
              
              (163
              )
              
              
              4,735Net
                  income
              
              $
              2,532
              
              
              $
              6,718
              
              
              $
              6,457
              
              
              $
              8,692**Net
                  income per share:**Basic
              
              $
              0.15
              
              
              $
              0.40
              
              
              $
              0.37
              
              
              $
              0.53Diluted
              
              $
              0.13
              
              
              $
              0.36
              
              
              $
              0.33
              
              
              $
              0.48**Shares
                  used to compute net income per share:**Basic
              
              
              17,461
              
              
              
              16,626
              
              
              
              17,388
              
              
              
              16,438Diluted
              
              
              19,407
              
              
              
              18,545
              
              
              
              19,336
              
              
              
              18,010
 
 
 *See
        Accompanying Notes to Condensed Consolidated Financial
        Statements*
 
 
  -
            4
            -
  **Interactive
        Intelligence, Inc.**
 **Condensed
        Consolidated Statement of Shareholders’ Equity (unaudited)**
 **For
        the Nine Months Ended September 30, 2007**
 **(In
        thousands)**
 
 **Common
                    Stock****Shares**
              
              
              **Amount**
              
              
              **Additional**
                  **Paid-in
                    Capital**
              
              
              **Accumulated
                    Deficit**
              
              
              **Total****Balances,
                  December 31, 2006**
              
              
              17,139
              
              
              $
              171
              
              
              $
              72,528
              
              
              $
              (48,421
              )
              
              $
              24,278Issuances
                  of common stock
              
              
              8
              
              
              
              --
              
              
              
              150
              
              
              
              --
              
              
              
              150Exercise
                  of stock options
              
              
              387
              
              
              
              4
              
              
              
              1,624
              
              
              
              --
              
              
              
              1,628Stock-based
                  compensation
              
              
              --
              
              
              
              --
              
              
              
              2,286
              
              
              
              --
              
              
              
              2,286Net
                  income
              
              
              --
              
              
              
              --
              
              
              
              --
              
              
              
              6,457
              
              
              
              6,457**Balances,
                  September 30, 2007**
              
              
              17,534
              
              
              $
              175
              
              
              $
              76,588
              
              
              $
              (41,964
              )
              
              $
              34,799
 
 
 *See
        Accompanying Notes to Condensed Consolidated Financial
        Statements*
  -
            5
            -
  **Interactive
        Intelligence, Inc.**
 **Condensed
        Consolidated Statements of Cash Flows (unaudited)**
 **For
        the Nine Months Ended September 30, 2007 and 2006**
 **(In
        thousands)**
 
 **Nine
                  Months Ended**
                **September
                    30,****2007**
              
              
              **2006****Operating
                  activities:**Net
                  income
              
              $
              6,457
              
              
              $
              8,692Adjustments
                  to reconcile net income to net cash provided by operating
                  activities:Depreciation
              
              
              1,941
              
              
              
              1,327Accretion
                  of investment income
              
              
              (317
              )
              
              
              (51
              )Stock-based
                  compensation expense related to stock options
              
              
              2,286
              
              
              
              1,617Deferred
                  income tax
              
              
              --
              
              
              
              (5,000
              )Loss
                  on disposal of fixed assets
              
              
              --
              
              
              
              4Changes
                  in operating assets and liabilities:Accounts
                  receivable
              
              
              (8,191
              )
              
              
              (4,048
              )Prepaid
                  expenses
              
              
              (699
              )
              
              
              (1,733
              )Other
                  current assets
              
              
              216
              
              
              
              (71
              )Other
                  assets
              
              
              (49
              )
              
              
              (80
              )Accounts
                  payable and accrued liabilities
              
              
              1,192
              
              
              
              974Accrued
                  compensation and related expenses
              
              
              662
              
              
              
              372Deferred
                  product revenues
              
              
              908
              
              
              
              301Deferred
                  services revenues
              
              
              5,426
              
              
              
              4,328Net
                  cash provided by operating activities
              
              
              9,832
              
              
              
              6,632**Investing
                  activities:**Purchases
                  of available-for-sale investments
              
              
              (15,192
              )
              
              
              (10,895
              )Sales
                  of available-for-sale investments
              
              
              18,115
              
              
              
              5,189Purchases
                  of property and equipment
              
              
              (3,601
              )
              
              
              (1,866
              )Acquisition
                  of professional services division
              
              
              (1,033
              )
              
              
              --Net
                  cash used in investing activities
              
              
              (1,711
              )
              
              
              (7,572
              )**Financing
                  activities:**Proceeds
                  from stock options exercised
              
              
              1,628
              
              
              
              2,258Proceeds
                  from issuance of common stock
              
              
              150
              
              
              
              138Net
                  cash provided by financing activities
              
              
              1,778
              
              
              
              2,396Net
                  increase in cash and cash equivalents
              
              
              9,899
              
              
              
              1,456Cash
                  and cash equivalents, beginning of period
              
              
              13,531
              
              
              
              11,551Cash
                  and cash equivalents, end of period
              
              $
              23,430
              
              
              $
              13,007Cash
                  paid during the period for:Interest
              
              $
              --
              
              
              $
              46Income
                  taxes
              
              
              147
              
              
              
              314
 
 
 *See
        Accompanying Notes to Condensed Consolidated Financial
        Statements*
  -
            6
            -
  **Interactive
        Intelligence, Inc.**
 **Notes
        to Condensed Consolidated Financial Statements**
 **September
        30, 2007 and 2006 (unaudited)**
 
 **1.**
              **THE
                  COMPANY**
  Interactive
        Intelligence, Inc. (the “Company”) is a leading provider of software
        applications for contact centers and is leveraging that leadership position
        to
        provide mission critical voice over Internet protocol (“VoIP”) applications to
        enterprises. The Company’s products are installed at international corporations,
        public agencies, telecommunication companies, distributed organizations,
        government and commercial enterprises. The Company participates in three
        distinct markets, all of whose needs are increasing for VoIP-based
        systems:
 
 ·
              Contact
                  Centers
 
 ·
              Enterprise
                  IP Telephony
 
 ·
              Enterprise
                  Messaging
  The
        Company commenced principal operations in 1994 and revenues were first
        recognized in 1997. Since then, the Company has established wholly-owned
        subsidiaries in Australia, France, the Netherlands and the United Kingdom.
        The
        Company also currently has international branch offices in Canada, Germany,
        China, Japan, Korea, Malaysia, Singapore and Sweden. The Company markets
        its
        software applications in the Americas, Europe, the Middle East, Africa, and
        Asia/Pacific.
 
 The
        accompanying unaudited condensed consolidated financial statements have been
        prepared in conformity with accounting principles generally accepted in the
        United States of America for interim financial information and with the
        instructions for Form 10-Q and Article 10 of Regulation S-X. Accordingly,
        certain information and footnote disclosures normally included in financial
        statements prepared in accordance with accounting principles generally accepted
        in the United States of America have been condensed, or omitted, pursuant
        to the
        rules and regulations of the Securities and Exchange Commission (the “SEC”). In
        the Company’s opinion, the condensed consolidated financial statements include
        all adjustments necessary (which are of a normal and recurring nature) for
        the
        fair presentation of the results of the interim periods presented.
 
 The
        accompanying condensed consolidated balance sheet at December 31, 2006 has
        been
        derived from the audited consolidated financial statements at that date but
        does
        not include all of the information and footnotes required by accounting
        principles generally accepted in the United States of America for complete
        financial statements.
 
 These
        condensed consolidated financial statements should be read in conjunction
        with
        the Company’s audited consolidated financial statements for the year ended
        December 31, 2006, included in the Company’s most recent Annual Report on Form
        10-K as filed with the SEC. The Company’s results of operations for any interim
        period are not necessarily indicative of the results of operations for any
        other
        interim period or for a full fiscal year.
  -
            7
            -
  **Interactive
        Intelligence, Inc.**
 **Notes
        to Condensed Consolidated Financial Statements (continued)**
 
 **2.**
              **SUMMARY
                  OF SIGNIFICANT ACCOUNTING
                  POLICIES**
 
 *Principles
        of Consolidation*
 
 The
        accompanying condensed consolidated financial statements include the accounts
        of
        the Company and its wholly-owned subsidiaries after elimination of all
        significant intercompany accounts and transactions.
 
 *Use
        of Estimates*
 
 The
        preparation of the accompanying condensed consolidated financial statements
        in
        conformity with accounting principles generally accepted in the United States
        requires management to make estimates and assumptions that affect the amounts
        reported in the financial statements and accompanying notes. Despite
        management’s best effort to establish good faith estimates and assumptions,
        actual results could differ from these estimates.
 
 *Revenue
        Recognition*
 
 The
        Company generates product revenues from licensing the right to use its software
        applications and in certain instances providing hardware as a component of
        its
        solution, and generates services revenues primarily from annual support fees,
        annual renewal fees, professional services and educational
        services.
 
 *Product
        Revenues*
 
 The
        Company’s license agreements are either perpetual or annually
        renewable.  For any revenues to be recognized from a license
        agreement, the following criteria must be met:
 
 ·
              Persuasive
                  evidence of an arrangement exists;
 
 ·
              The
                  fee is fixed or determinable;
 
 ·
              Collection
                  is probable; and
 
 ·      Delivery
        has occurred.
 
 For
        a
        perpetual license agreement, upon meeting the revenue recognition criteria
        above, the Company immediately recognizes as product revenues the amount
        of
        initial license fees if sufficient vendor specific objective evidence of
        fair
        value (“VSOE”) exists to support allocating a portion of the total fee to the
        undelivered elements of the arrangement. If sufficient VSOE of the undelivered
        elements does not exist, the Company recognizes the initial license fee as
        product revenues ratably over the initial term of the support agreement once
        support is the only undelivered element. The support period is generally
        12
        months but may be up to 18 months for initial orders because support begins
        when
        the licenses are downloaded, when support commences, or no more than six
        months
        following the contract date. The Company determines VSOE of support in perpetual
        agreements based on substantive renewal rates the customer must pay to renew
        the
        support. The VSOE of other services is based on amounts charged when the
        services are sold in stand-alone sales.
 
 For
        an
        annually renewable license agreement, upon meeting the revenue recognition
        criteria above, the Company recognizes a majority of the initial license
        fees
        under these agreements as product revenues ratably over the initial license
        period, which is generally 12 months, and the remainder of the initial license
        fees are recognized as services revenues over the same time period.
 
 The
        Company recognizes revenues related to any hardware sales when the hardware
        is
        delivered and all other revenue recognition criteria are met.
 
 *Services
        Revenues*
 
 Services
        revenues are primarily recognized for renewal fees and support related to
        annually renewable license agreements and support fees for perpetual license
        agreements. For annually renewable agreements, the allocation of the initial
        order between product revenues and services revenues is based on the average
        renewal rates of all time based contracts. The Company applies the allocation
        of
        product revenues and services revenues consistently to all annually renewable
        agreements. Under annually renewable license agreements, after the initial
        license period, the Company’s customers may renew their license agreement for an
        additional period, typically 12 months, by paying a renewal fee. The revenue
        for
        the annual renewal fees are all classified under services revenue and the
        revenue is recognized ratably over the contract period. Under perpetual license
        agreements, the Company recognizes annual support fees as services revenues
        ratably over the post-contract support period, which is typically 12
        months.
 
  -
            8
            -
  **Interactive
        Intelligence, Inc.**
 **Notes
        to Condensed Consolidated Financial Statements (continued)**
 
 The
        Company also generates revenues from other services that it provides to its
        partners and customers. These additional revenues include fees for professional
        services and educational services. Revenues from professional services, which
        include implementing the Company’s products for a customer, and educational
        services, which consist of training courses for partners and customers, are
        recognized as the related services are performed.
 
 *Stock-Based
        Compensation*
 
 The
        Company accounts for its employee and director stock options in accordance
        with
        Financial Accounting Standards Board (“FASB”) Statement of Financial Accounting
        Standards (“SFAS”) No. 123 (revised 2004), *Share-Based Payment* (“SFAS
        123R”) and the guidance of the SEC Staff Accounting Bulletin No. 107 (“SAB
        107”), which requires the measurement and recognition of compensation expense
        for all share-based payment awards made to employees and directors, based
        on
        fair values.  As permitted by SFAS 123R, the Company used the
        Black-Scholes option-pricing model as its method of valuation for share-based
        payment awards. The Company’s determination of fair value of share-based payment
        awards on the date of grant using an option-pricing model is affected by
        the
        Company’s stock price as well as assumptions regarding a number of highly
        complex and subjective variables. These variables include, but are not limited
        to, the Company’s expected stock price volatility over the term of the awards
        and an expected risk-free rate of return. If factors change and the Company
        uses
        different assumptions for estimating stock-based compensation expense in
        future
        periods, stock-based compensation expense may differ materially in the future
        from that recorded in the current period.
 
 Stock-based
        compensation expense for employee stock options recognized under SFAS 123R
        for
        the three and nine months ended September 30, 2007 was $812,000 and $2.3
        million, respectively, compared to $451,000 and $1.6 million during the same
        periods in 2006.
 
 *Income
        Taxes*
 
 Income
        taxes are accounted for under the asset and liability method. Deferred tax
        assets and liabilities are recognized for the future tax consequences
        attributable to differences between the financial statement carrying amounts
        of
        existing assets and liabilities and their respective tax bases and operating
        loss and tax credit carry-forwards. Deferred tax assets and liabilities are
        measured using enacted tax rates expected to apply to taxable income in the
        years in which those temporary differences are expected to be recovered or
        settled. The effect on deferred tax assets and liabilities of a change in
        tax
        rates is recognized in income in the period that includes the enactment
        date.
 
 SFAS
        No.
        109, *Accounting for Income Taxes* (“SFAS 109”), establishes financial
        accounting and reporting standards for the effect of income taxes. The Company
        is subject to income taxes in both the United States and numerous foreign
        jurisdictions. Significant judgment is required in evaluating the Company’s tax
        positions and determining its provision for income taxes. The objectives
        of
        accounting for income taxes are to recognize the amount of taxes payable
        or
        refundable for the current year and deferred tax liabilities and assets for
        the
        future tax consequences of events that have been recognized in an entity’s
        financial statements or tax returns. Variations in the actual outcome of
        these
        future tax consequences could materially impact the Company’s financial
        position, results of operations, or cash flows.
 
 In
        assessing the recoverability of deferred tax assets, management considers
        whether it is more likely than not that some portion or all of the deferred
        tax
        assets will not be realized. The ultimate realization of deferred tax assets
        is
        dependent upon generation of future taxable income during the periods in
        which
        temporary differences become deductible. Management considers projected future
        taxable income and tax planning strategies in making this assessment and
        ensuring that the deferred tax asset valuation allowance is adjusted as
        appropriate.
 
 See
        Note
        7 for further information on the Company’s income taxes.
 
 *Legal
        Proceedings*
 
 Liabilities
        for loss contingencies arising from claims, assessments, litigation, fines,
        and
        penalties and other sources are recorded when it is probable that a liability
        has been incurred and the amount of the assessment and/or remediation can
        be
        reasonably estimated. Legal costs incurred in connection with loss contingencies
        are expensed as incurred.
 
 *Reclassifications*
 
 Certain
        reclassifications have been
        made to prior year amounts to conform to the current period
        presentation.
 
 Prior
        to
        January 1, 2007, costs related to the development of the Company’s packaged
        solutions were included in cost of services. Beginning January 1, 2007, for
        all
        periods, these costs have been reclassified from cost of services to research
        and development expenses.  Prior to July 1, 2007, costs related to
        certain commissions for the sale of services were included in cost of services.
        Beginning July 1, 2007, for all periods, these costs have been reclassified
        from cost of services to sales and marketing expenses. Prior
        to
        October 1, 2006, costs related to our skill development funds, which were
        incurred by us as incentives for our partners, were included in sales and
        marketing expenses. Beginning October 1, 2006, for all periods, these costs
        have
        been reclassified as a reduction in product revenues as they are contingent
        on
        our partners’ sales activity.
  As
        these
        reclassifications occurred between line items on the consolidated statement
        of
        income for the respective periods, they have had no impact on operating income,
        net income or earnings per share as previously reported.
  -
            9
            -
  **Interactive
        Intelligence, Inc.**
 **Notes
        to Condensed Consolidated Financial Statements (continued)**
 
 **3.**
              **NET
                  INCOME PER SHARE**
 
 Basic
        net
        income per share is calculated based on the weighted-average number of common
        shares outstanding in accordance with SFAS No. 128, *Earnings per Share*.
        Diluted net income per share is calculated based on the weighted-average
        number
        of common shares outstanding plus the effect of dilutive potential common
        shares. When the Company reports net income, the calculation of diluted net
        income per share excludes shares underlying stock options outstanding that
        would
        be antidilutive. Potential common shares are composed of shares of common
        stock
        issuable upon the exercise of stock options (in thousands, except per share
        amounts).
 
 **Three
                    Months Ended**
                  **September
                    30,**
              
              
              **Nine
                    Months Ended**
                  **September
                    30,****2007**
              
              
              **2006**
              
              
              **2007**
              
              
              **2006****Net
                  income, as reported (A)**
              
              $
              2,532
              
              
              $
              6,718
              
              
              $
              6,457
              
              
              $
              8,692Weighted
                  average shares of common stock outstanding (B)
              
              
              17,461
              
              
              
              16,626
              
              
              
              17,388
              
              
              
              16,438Dilutive
                  effect of employee stock options
              
              
              1,946
              
              
              
              1,919
              
              
              
              1,948
              
              
              
              1,572Common
                  stock and common stock equivalents (C)
              
              
              19,407
              
              
              
              18,545
              
              
              
              19,336
              
              
              
              18,010**Net
                  income per share:**Basic
                  (A/B)
              
              $
              0.15
              
              
              $
              0.40
              
              
              $
              0.37
              
              
              $
              0.53Diluted
                  (A/C)
              
              
              0.13
              
              
              
              0.36
              
              
              
              0.33
              
              
              
              0.48
 
 The
        Company’s calculation of diluted net income per share for the three months ended
        September 30, 2007 and 2006 excludes stock options to purchase approximately
        756,000 and 362,000 shares of the Company’s common stock, respectively, and
        diluted net income per share for the nine months ended September 30, 2007
        and
        2006, excludes stock options to purchase approximately 618,000 and 379,000
        shares of the Company’s common stock, respectively, as their effect would be
        antidilutive.
 
 **4.**
              **STOCK-BASED
                  COMPENSATION**
 
 The
        Company’s Stock Option Plans, adopted in 1995, 1999 and 2006, authorize the
        Board of Directors or the Compensation Committee, as applicable, to grant
        incentive and nonqualified stock options, and, in the case of the 2006 Equity
        Incentive Plan (the “2006 Plan”), stock appreciation rights, restricted stock,
        restricted stock units, performance shares, performance units and other
        stock-based awards. After adoption of the 2006 Plan, the Company may no longer
        issue grants from previous plans, but any shares subject to awards under
        the
        1999 Stock Option and Incentive Plan and the Outside Directors Stock Option
        Plan
        (collectively, the “1999 Plans”) that are cancelled will be added to shares
        available under the 2006 Plan. The number of shares available under the 2006
        Plan is subject to adjustment for certain changes in the Company’s capital
        structure. The exercise price of options granted under the 2006 Plan is equal
        to
        the closing price of the Company’s common stock, as reported by The NASDAQ
        Global Market, on the last trading day prior to the date of grant.
 
 Prior
        to
        2007, options were granted based on historical performance after the Company’s
        quarterly and/or annual results were known, and generally vested in equal
        annual
        installments over four years from the first anniversary of the date of grant.
        In
        fiscal 2007, the Company began granting stock options as of the beginning
        of the
        year. Stock option grants are now categorized into two groups: (1) non-executive
        officer and director grants and (2) executive officer grants.  Stock
        options granted to non-executive officers and directors are subject only
        to time
        vesting.  The fair value of these non-executive officer and director
        option grants is determined on the date of grant and the related compensation
        expense is recognized for the entire award on a straight-line basis over
        the
        vesting period.  Stock options granted to executive officers are
        subject to cancellation if specified performance targets for fiscal 2007
        (as
        defined in the executives’ 2007 compensation plans) are not
        achieved.  If the applicable performance targets are achieved, the
        options will vest in four equal annual installments beginning January 1,
        2009.  The fair value of the executive officer option grants is
        determined on the date of grant and the related compensation
        expense  is recognized over the requisite service period, including
        the initial period for which the performance targets must be met, for each
        separately vesting portion of the award as if each vesting tranche was a
        separate award.  The valuation assumptions used for each method are
        similar, although tailored for each vesting tranche of the awards for the
        executive officer grants.
 
  -
            10
            -
  **Interactive
        Intelligence, Inc.**
 **Notes
        to Condensed Consolidated Financial Statements (continued)**
 
 For
        most
        options granted through December 31, 2004, the term of each option is ten
        years
        from the date of grant. In 2005, the Company began issuing options with a
        term
        of six years from the date of grant.
 
 If
        an
        incentive stock option is granted to an employee who, at the time the option
        is
        granted, owns stock representing more than ten percent of the voting power
        of
        all classes of stock of the Company, the exercise price of the option may
        not be
        less than 110% of the market value per share on the date the option is granted
        and the term of the option shall be not more than five years from the date
        of
        grant.
 
 The
        plans
        may be terminated by the Company’s Board of Directors at any time.
 
 *Expense
        Information under SFAS 123R*
 
 The
        following table summarizes the allocation of stock-based compensation expense
        related to employee and director stock options under SFAS 123R for the three
        and
        nine months ended September 30, 2007 and 2006 and their related impact on
        net
        income per share (in thousands, except per share amounts):
 
 **Three
                    Months Ended**
                  **September
                    30,**
              
              
              **Nine
                    Months Ended**
                  **September
                    30,****2007**
              
              
              **2006**
              
              
              **2007**
              
              
              **2006****Stock-based
                  compensation expense by category:**Cost
                  of services
              
              $
              70
              
              
              $
              38
              
              
              $
              184
              
              
              $
              116Sales
                  and marketing
              
              
              313
              
              
              
              219
              
              
              
              943
              
              
              
              768Research
                  and development
              
              
              153
              
              
              
              69
              
              
              
              411
              
              
              
              179General
                  and administrative
              
              
              276
              
              
              
              125
              
              
              
              748
              
              
              
              545**Total
                  stock-based compensation expense**
              
              $
              812
              
              
              $
              451
              
              
              $
              2,286
              
              
              $
              1,608**Effect
                  of stock-based compensation expense on net income per
                  share:**Basic
              
              $
              (0.05
              )
              
              $
              (0.03
              )
              
              $
              (0.13
              )
              
              $
              (0.10
              )Diluted
              
              $
              (0.04
              )
              
              $
              (0.02
              )
              
              $
              (0.12
              )
              
              $
              (0.09
              )
 
 **5.**
              **CONCENTRATION
                  OF CREDIT RISK**
 
 No
        customer or partner represented a greater than 10% concentration of the
        Company’s accounts receivable as of September 30, 2007 or December 31, 2006. In
        addition, no customer or partner had greater than 10% concentration of the
        Company’s revenues for the three and nine months ended September 30, 2007 and
        2006.
 
 **6.**
              **COMMITMENTS
                  AND CONTIGENCIES**
 
 *Legal
        Proceedings*
 
 From
        time
        to time, the Company has received notification from competitors and other
        technology providers claiming that the Company’s technology infringes their
        proprietary rights. The Company cannot assure you that these matters can
        be
        resolved amicably without litigation, or that the Company will be able to
        enter
        into licensing arrangements on terms and conditions that would not have a
        material adverse effect on its business, financial condition or results of
        operations.
 
 In
        November 2002, the Company received a notification from the French government
        as
        a result of a tax audit that had been conducted encompassing the years 1998,
        1999, 2000 and 2001. In December 2005, the Company received an additional
        notification from the French government as a result of an updated tax audit
        that
        they conducted. Both of these assessments claim various taxes are owed related
        to Value Added Tax (“VAT”) and corporation taxes in addition to what has
        previously been paid and accrued. In May 2007, the French court ruled against
        the Company on the first notification and declared the amounts due ($3.3
        million
        for VAT and $332,000 for corporation taxes). Because the judgment from the
        French court was against Interactive Intelligence France S.A.R.L. (the “SARL”),
        a wholly owned subsidiary of the Company, the Company does not believe that
        the
        French government can impose the liability on Interactive Intelligence, Inc.
        and
        the SARL does not have any significant assets with which to pay.  In
        addition, the Company’s tax counsel and advisors contend that the case is
        without merit and the Company has two more appeal routes, which could take
        up to
        ten years to resolve.
 
 As
        of
        September 30, 2007, the assessment related to VAT was approximately $6.0
        million
        and the assessment related to corporation taxes was approximately
        $723,000.  As of September 30, 2007, the Company has recorded what it
        deems an appropriate amount for the corporate tax assessment. No accrual
        has
        been made by the Company with respect to the VAT assessment.
 
 
  -
            11
            -
  **Interactive
        Intelligence, Inc.**
 **Notes
        to Condensed Consolidated Financial Statements (continued)**
 
 The
        Company has filed for VAT refunds in France of more than $600,000, which
        the
        Company has not recorded as a receivable and to which the French government
        has
        not yet responded. The Company believes that these VAT refunds could be used
        to
        offset amounts owed to the French government in connection with the assessments,
        if necessary.  Although the Company is appealing both the VAT and
        corporation tax assessments, it cannot assure you that these matters will
        be
        resolved without further litigation or that it will not have to pay some
        or all
        of the assessments.
 
 From
        time
        to time, the Company is also involved in certain legal proceedings in the
        ordinary course of conducting its business. While the ultimate liability
        pursuant to these actions cannot currently be determined, the Company believes
        these legal proceedings will not have a material adverse effect on its financial
        position or results of operations. Litigation in general, and intellectual
        property litigation in particular, can be expensive and disruptive to normal
        business operations. Moreover, the results of complex legal proceedings are
        difficult to predict.
 
 *Lease
        Commitment*
 
 During
        the second quarter of 2007, the Company entered into an amendment of its
        corporate office operating lease under which the current leased space will
        be
        expanded to an office building currently under construction and adjacent
        to the
        Company’s corporate headquarters. The rent for the additional space through the
        lease expiration date will be approximately $16.3 million, payable in pro-rata
        monthly installments, as defined in the amendment and will commence as the
        Company utilizes the additional space, which is expected to be no earlier
        than
        March 1, 2008. In consideration for entering into the amendment, the landlord
        agreed to pay the Company a discretionary allowance of $450,000 which is
        payable
        as the Company utilizes the additional space in the office building. The
        Company
        intends to use this allowance for certain costs associated with the Company’s
        corporate headquarters and/or the additional space, as defined in the amendment.
        This amendment did not have any financial statement impact, and there were
        no
        material changes related to this amendment, during the quarter ended September
        30, 2007.
 
 *Other
        Contingencies*
 
 The
        Company has received and may continue to receive certain payroll tax credits
        and
        real estate tax abatements that were granted to the Company based upon certain
        growth projections.  If the Company’s actual results are less than those
        projections, the Company may be subject to repayment of some or all of the
        payroll tax credits or payment of additional real estate taxes in the case
        of
        the abatements.  The Company does not believe that it will be subject to
        payment of any money related to these taxes, however the Company cannot provide
        assurance as to the outcome.
 
 **7.**
              **INCOME
                  TAXES**
 
 The
        Company recorded its income taxes in accordance with SFAS 109. Management
        considers, when assessing the realizability of deferred tax assets, whether
        it
        is more likely than not that some portion or all of the deferred tax assets
        will
        not be realized. The ultimate realization of deferred tax assets is dependent
        upon the generation of future taxable income during the periods in which
        those
        temporary differences become deductible. Management considers the scheduled
        reversal of deferred tax liabilities, if any, projected future taxable income,
        and tax planning strategies in making this assessment.
 
  -
            12
            -
  **Interactive
        Intelligence, Inc.**
 **Notes
        to Condensed Consolidated Financial Statements (continued)**
 
 The
        Company had $44.1 million of tax net operating loss carry-forwards and $4.7
        million in tax credit carry-forwards at December 31, 2006. Included in the
        net
        operating loss carry-forwards was $8.7 million related to disqualifying
        dispositions of stock options. The tax benefit of the disqualifying tax
        dispositions deductions, if realized for financial reporting purposes, will
        be
        recorded as a credit to additional paid-in capital.
 
 During
        the third quarter of 2006, the Company recorded a non-cash tax benefit of
        $5.0
        million to reduce the valuation allowance for its deferred tax assets as
        a
        result of improved performance of the business during the prior three years
        and
        the level of projections for future taxable income during the periods in
        which
        the deferred tax assets are deductible. The Company had a valuation allowance
        of
        $20.9 million at December 31, 2006. Management will continue to evaluate
        the
        recoverability of the deferred tax assets on a quarterly basis and will adjust,
        as necessary, the valuation allowance to reflect deferred tax assets deemed
        more
        likely than not to be recovered.
 
 Effective
        January 1, 2007, the Company adopted FASB Interpretation No. 48, *Accounting
        for Uncertainty in Income Taxes an interpretation of FASB Statement No. 109*
        (“FIN 48”).  FIN 48 prescribes a recognition threshold and measurement
        attributes for the financial statement recognition and measurement of a tax
        position taken or expected to be taken in a tax return.  Adoption of
        FIN 48 had no impact on the Company’s consolidated financial position and
        results of operations.
 
 Upon
        adoption of FIN 48, the Company identified an uncertain tax position related
        to
        certain tax credits that the Company currently believes may not meet the
“more
        likely than not” recognition threshold under FIN 48 to be sustained upon
        examination. Since this uncertain tax position has not been utilized and
        had a
        full valuation allowance established, the effect would be to reduce the gross
        deferred tax asset and valuation allowance by up to $4.7 million. This amount
        relates to unrecognized tax benefits that would impact the effective tax
        rate if
        recognized absent the valuation allowance. The Company and its subsidiaries
        file
        income tax returns in the U.S. federal jurisdiction, and various states and
        foreign jurisdictions.  Tax years 2004 and forward remain open for
        examination for federal tax purposes and tax years 2003 and forward remain
        open
        for examination for the Company’s more significant state tax
        jurisdictions.  To the extent utilized in future years’ tax returns,
        net operating loss and capital loss carry forwards at September 30, 2007
        will
        remain subject to examination until the respective tax year is
        closed.
 
 **8.**
              **ACQUISITION**
 
 *Asset
        Purchase Agreement*
 
 During
        the second quarter of 2007, the Company entered into an asset purchase agreement
        with Alliance Systems Ltd. (“Alliance”), and $853,000 in cash was paid to
        Alliance on the date of the acquisition. In connection with the acquisition,
        during July 2007 a hold back provision for $180,000 was paid in full to
        Alliance, upon achievement of certain conditions as specified in the asset
        purchase agreement.  Except for this payment of the hold back, there
        were no material changes related to this acquisition during the quarter ended
        September 30, 2007.
 
 The
        purchase price allocations for the Company’s acquisition of the professional
        services division of Alliance were based on a third-party valuation report
        which
        was prepared in accordance with the provisions of SFAS No. 141, *Business
        Combinations* (“SFAS No. 141”) and are subject to adjustment. The following
        table summarizes the fair value of the intangible and other assets acquired
        and
        liabilities assumed at the date of acquisition (in thousands):
 
 Goodwill
              
              $
              996Customer
                  relationships
              
              
              50Fixed
                  assets
              
              
              36Total
                  assets acquired
              
              $
              1,082Deferred
                  services revenue
              
              
              (49
              )**Net
                  assets acquired**
              
              $
              1,033
 
 The
        premium paid over the fair value of the net assets acquired in the purchase,
        or
        goodwill, was primarily attributed to expected synergies from the Company’s
        acquisition of a professional services team having prior experience with
        the
        Company’s solutions and their implementation.
  -
            13
            -
  **Interactive
        Intelligence, Inc.**
 **Notes
        to Condensed Consolidated Financial Statements (continued)**
 
 *Goodwill*
 
 As
        a
        result of recording goodwill related to the acquisition discussed above,
        goodwill will be reviewed for impairment at least annually, during the fourth
        quarter, in accordance with the provisions of SFAS No. 142, *Goodwill
        and Other Intangible Assets*. The goodwill impairment test is a two-step
        test. Under the first step, the fair value of the reporting unit is compared
        with its carrying value (including goodwill). If the fair value of the reporting
        unit is less than its carrying value, an indication of goodwill impairment
        exists for the reporting unit and the Company must perform step two of the
        impairment test (measurement). Under step two, an impairment charge is
        recognized for any excess of the carrying amount of the reporting unit’s
        goodwill over the implied fair value of that goodwill.
 
 The
        implied fair value of goodwill is determined by allocating the fair value
        of the
        reporting unit in a manner similar to a purchase price allocation, in accordance
        with SFAS No. 141. The residual fair value after this allocation is the
        implied fair value of the reporting unit goodwill. Fair value of the reporting
        unit is determined using a discounted cash flow analysis. For purposes of
        the
        impairment test, the Company is considered one reporting unit.
 
 **9.**
              **RECENT
                  ACCOUNTING PRONOUNCEMENTS**
 
 In
        February 2007, the FASB issued SFAS No. 159, *The Fair Value Option for
        Financial Assets and Financial Liabilities - Including an amendment of SFAS
        No.
        115*, *Accounting for Certain Investments in Debt and Equity
        Securities* (“SFAS 159”). SFAS 159 permits entities to choose to measure
        many financial assets and financial liabilities at fair value. Unrealized
        gains
        and losses on items for which the fair value option has been elected are
        reported in earnings. SFAS 159 is effective for the fiscal year beginning
        January 1, 2008.  The Company is currently evaluating the impact, if
        any, of the adoption of SFAS 159. The Company does not expect the adoption
        of
        SFAS 159 will have a material impact on its consolidated financial position,
        results of operations or cash flows.
 
 In
        September 2006, the FASB issued SFAS No. 157, *Fair Value Measurements*(“SFAS 157”). SFAS 157 defines fair value, establishes a framework for
        measuring fair value in generally accepted accounting principles and expands
        disclosures about fair value measurements. This Statement applies to previous
        accounting pronouncements that require or permit fair value measurements.
        Accordingly, this Statement does not require any new fair value measurements.
        SFAS 157 is effective for the fiscal year beginning January 1, 2008. The
        Company
        is currently evaluating the impact, if any, of the adoption of SFAS 157.
        The
        Company does not expect the adoption of SFAS 157 will have a material impact
        on
        its consolidated financial position, results of operations or cash
        flows.
  -
            14
            -
  
 **Item
                  2.**
              **Management’s
                  Discussion and Analysis of Financial Condition and Results of
                  Operations.**
 
 The
        following Management’s Discussion and Analysis of Financial Condition and
        Results of Operations is intended to provide our investors with an understanding
        of our past performance, our financial condition and our prospects and should
        be
        read in conjunction with other sections of this Quarterly Report on Form
        10-Q.
        Investors should carefully review the information contained in this report
        under
        Part II, Item 1A “Risk Factors” and in the Item 1A “Risk Factors” section of our
        Annual Report on Form 10-K for the fiscal year ended December 31, 2006. The
        following will be discussed and analyzed:
  ·      Forward-Looking
        Information
 
 ·      Overview
 
 ·      Financial
        Highlights
 
 ·      Historical
        Results of Operations
 
 ·      Liquidity
        and Capital Resources
 
 ·      Critical
        Accounting Policies and Estimates
 
 **Forward-Looking
        Information**
 
 Certain
        statements in this Quarterly Report on Form 10-Q contain “forward-looking”
information (as defined in the Private Securities Litigation Reform Act of
        1995,Section
        27A
        of the Securities Act of 1933, as amended and Section 21E of the Securities
        Exchange Act of 1934, as amended) that involves risks and uncertainties which
        may cause actual results to differ materially from those predicted in the
        forward-looking statements. Forward-looking statements can often be identified
        by their use of such verbs as “expects”, “anticipates”, “believes”, “intend”,
“plan”, “may”, “should”, “will”, “would”, “will be”, “will continue”, “will
        likely result”, or similar verbs or conjugations of such verbs. If any of our
        assumptions on which the statements are based prove incorrect or should
        unanticipated circumstances arise, our actual results could materially differ
        from those anticipated by such forward-looking statements. The differences
        could
        be caused by a number of factors or combination of factors, including, but
        not
        limited to, rapid technological changes in the industry; our ability to maintain
        profitability, to manage successfully our growth and increasingly complex
        third
        party relationships, to maintain successful relationships with our current
        and
        any new partners, to maintain and improve our current products and to develop
        new products and to protect our proprietary rights adequately; and other
        factors
        set forth in our Securities and Exchange Commission (“SEC”) filings, including
        the Item 1A “Risk Factors” section of our Annual Report on Form 10-K for the
        fiscal year ended December 31, 2006.
  **Overview**
 
 Interactive
        Intelligence, Inc. (“Interactive Intelligence”, “we”, “us” or “our”) was formed
        in 1994 as an Indiana corporation and maintains its world headquarters and
        executive offices at 7601 Interactive Way, Indianapolis, IN 46278. Our telephone
        number is (317) 872-3000. You can find our website at
*http://www.inin.com*. Our periodic and current reports and all
        amendments to those reports required to be filed or furnished pursuant to
        Section 13(a) or 15(d) of the Securities Exchange Act of 1934 are available
        free
        of charge through our investor relations page located on our Website at
*http://www.inin.com**/investors*.
 
 We
        are a
        leading provider of software applications for contact centers and we are
        leveraging that leadership position to provide mission critical voice over
        Internet protocol (“VoIP”) applications to enterprises. Our solutions are
        utilized in contact centers of international corporations, public agencies,
        telecommunications companies, distributed organizations, government and
        commercial enterprises, and increasingly for the remote and mobile workforce.
        We
        also offer a pre-integrated all-software Internet Protocol Private Branch
        Exchange (“IP PBX”), a phone and communications solution for mid-sized
        enterprises that relies on the Microsoft Corporation (“Microsoft”) platform. We
        offer innovative software products and services for multi-channel contact
        management, business communications, messaging and session initiation protocol
        (“SIP”)-supported VoIP.
 
  -
            15
            -
  Our
        application-based solutions are integrated on a platform that scales to
        thousands of users, and are developed to satisfy today’s diverse interaction
        needs in markets for:
 
 ·
              Contact
                  Centers
 
 ·
              Enterprise
                  IP Telephony
 
 ·
              Enterprise
                  Messaging
 
 By
        implementing our all-in-one solutions, businesses are able to unify
        communications, enhance workforce effectiveness and productivity, and readily
        adapt to constantly changing market and customer requirements. Moreover,
        organizations are able to reduce the cost and complexity of traditional
“multi-point” legacy communications hardware systems that are seldom fully
        integrated.
 
 **Financial
        Highlights**
 
 For
        the
        three months ended September 30, 2007, revenues grew 6% over the previous
        three
        month period and 31% over the three months ended September 30, 2006. The
        increase takes into account a reclassification in the third quarter of 2006
        related to our skills development funds as discussed in Note 2 of our Notes
        to
        Condensed Consolidated Financial Statements (“Note 2”).
 
 Factors
        that affect revenues in any particular quarter include potential customers’
budget constraints, personnel resources to implement our solutions, historical
        product order patterns and willingness to implement a critical
        telecommunications system. Revenues in any particular quarter can greatly
        fluctuate from other periods.
 
 The
        amount of orders we receive, while impacting product revenues, does not have
        an
        exact correlation to revenues because the terms in the contracts, collection
        history with the customer or partner, and any other contractual conditions
        affect whether we can recognize the order during the quarter or in subsequent
        quarters.  Consequently, product revenues for any particular quarter
        are impacted not only by orders received in the current quarter but also
        by
        orders received in previous quarters that are being recognized in the current
        quarter.
 
 The
        information below shows our total revenues (in millions) for the most recent
        five quarters and the years ended December 31, 2006, 2005 and 2004 and the
        percentage change over the previous period (including the impact of the 2006
        reclassification discussed above and in Note 2).
 
 **Period**
              
              **Revenues**
              
              
              **%
                  Growth**Three
                  months ended:September
                  30, 2007
              
              $
              28.7
              
              
              
              6
              %June
                  30, 2007
              
              
              27.0
              
              
              
              12March
                  31, 2007
              
              
              24.2
              
              
              
              1December
                  31, 2006
              
              
              23.9
              
              
              
              8September
                  30, 2006
              
              
              22.0
              
              
              
              14Year
                  ended December 31:2006
              
              $
              83.0
              
              
              
              32
              %2005
              
              
              62.9
              
              
              
              142004
              
              
              55.1
              
              
              
              7
 
 Product
        revenues increased during the three and nine months ended September 30, 2007,
        compared to the same periods in 2006, as a result of increased demand for
        our
        software and appliances, third party products we license and third party
        hardware we sell. We have experienced increasing annual revenue growth in
        all
        major geographies in part due to an increase in demand for our contact center
        solutions. We also attribute annual revenue growth to a number of other factors
        including but not limited to: adoption of VoIP technologies by our customers;
        increasing market awareness of our solutions; improvements in scalability
        and
        the reliability of our products; reductions in hardware costs to deploy our
        solutions making our solutions more financially attractive to customers;
        changes
        in our sales program to target new customers; and establishment of an inside
        sales group to work with current customers.
 
 Services
        revenues increased significantly during the three and nine months ended
        September 30, 2007, compared to the same periods in 2006, primarily due to
        additional support fees and annually renewable license fees, which were
        recognized for our growing installed customer base, and an increase in revenues
        from professional services as more of our larger, direct customers utilized
        our
        professional services group to assist in implementing our
        solutions.
 
 Our
        costs
        of products continue to increase due to appliances we have developed and
        licensed, additional hardware delivered by us and increased royalty expenses
        as
        a result of licensing more third party software as part of the orders
        received.
 
 Costs
        of
        services and operating expenses for the three and nine months ended September
        30, 2007 increased significantly compared to the same periods in 2006 primarily
        due to a 26% increase in company-wide staffing at September 30, 2007 compared
        to
        September 30, 2006 and related costs.
  -
            16
            -
  
 Since
        January 1, 2006, we have accounted for our employee and director stock options
        in accordance with Financial Accounting Standards Board (“FASB”) Statement of
        Financial Accounting Standards (“SFAS”) No. 123 (revised 2004), *Share-Based
        Payment* (“SFAS 123R”) and the guidance of the SEC Staff Accounting Bulletin
        No. 107 (“SAB 107”), which requires the measurement and recognition of
        compensation expense for all share-based payment awards made to employees
        and
        directors, based on fair values. As a result, we have incurred stock-based
        compensation expense each quarter as stock options are granted and
        vested.  The following is a brief summary of our stock-based
        compensation expense for the three and nine months ended September 30, 2007
        and
        2006 and the related impact on net income per share (in thousands, except
        per
        share amounts):
 
 **Three
                    Months**
                  **Ended
                    September 30,**
              
              
              **Nine
                    Months**
                  **Ended
                    September 30,****2007**
              
              
              **2006**
              
              
              **2007**
              
              
              **2006****Total
                  stock-based compensation expense**
              
              $
              812
              
              
              $
              451
              
              
              $
              2,286
              
              
              $
              1,608**Effect
                  of stock-based compensation expense on net income per
                  share:**Basic
              
              $
              (0.05
              )
              
              $
              (0.03
              )
              
              $
              (0.13
              )
              
              $
              (0.10
              )Diluted
              
              $
              (0.04
              )
              
              $
              (0.02
              )
              
              $
              (0.12
              )
              
              $
              (0.09
              )
 
 Based
        on
        currently issued non-vested options as of September 30, 2007, we expect
        stock-based compensation expenses related to SFAS 123R to be approximately
        $835,000 for the fourth quarter of 2007.
 
 During
        the second quarter of 2007, we acquired certain intangible and other assets
        and
        assumed certain liabilities of the professional services division of Alliance
        for $1.0 million. A total of 13 professional services engineers and one sales
        representative joined our company immediately following the consummation
        of the
        acquisition. These individuals possessed previous experience with our solutions
        and their implementation. We funded the $1.0 million purchase price with
        cash
        available from operations, which also included a hold back provision of $180,000
        to cover costs for training and recruiting if any of the acquired Alliance
        employees left our company within 90 days after closing the
        transaction.  The hold back was paid in full in July 2007. This
        acquisition has enabled us to immediately expand our professional services
        group
        in an effort to more effectively support our customers. See Note 8 of Notes
        to
        Condensed Consolidated Financial Statements for further
        information.
 
 During
        the third quarter of 2006, we recorded a non-cash tax credit of $5.0 million
        to
        reduce the valuation allowance for our deferred tax assets. We had a valuation
        allowance of $20.9 million at December 31, 2006. We have not recorded a
        reduction of the deferred tax valuation allowance since the three months
        ended
        September 30, 2006; however, we continue to evaluate the recoverability of
        the
        deferred tax assets on a quarterly basis.
 
 **Historical
        Results of Operations**
 
 The
        following table presents certain financial data, derived from our unaudited
        statements of income, as a percentage of total revenues for the periods
        indicated. The operating results for the three and nine months ended September
        30, 2007 and 2006 are not necessarily indicative of the results that may
        be
        expected for the full year or for any future period.
 
 **Three
                    Months Ended**
                  **September
                    30,**
              
              
              **Nine
                    Months Ended**
                  **September
                    30,****2007**
              
              
              **2006**
              
              
              **2007**
              
              
              **2006****Revenues:**Product
              
              
              52
              %
              
              
              54
              %
              
              
              52
              %
              
              
              51
              %Services
              
              
              48
              
              
              
              46
              
              
              
              48
              
              
              
              49Total
                  revenues
              
              
              100
              
              
              
              100
              
              
              
              100
              
              
              
              100**Cost
                  of revenues:**Product
              
              
              15
              
              
              
              12
              
              
              
              13
              
              
              
              10Services
              
              
              19
              
              
              
              18
              
              
              
              19
              
              
              
              17Total
                  cost of revenues
              
              
              34
              
              
              
              30
              
              
              
              32
              
              
              
              27Gross
                  profit
              
              
              66
              
              
              
              70
              
              
              
              68
              
              
              
              73**Operating
                  expenses:**Sales
                  and marketing
              
              
              32
              
              
              
              34
              
              
              
              33
              
              
              
              36Research
                  and development
              
              
              15
              
              
              
              16
              
              
              
              16
              
              
              
              17General
                  and administrative
              
              
              11
              
              
              
              13
              
              
              
              12
              
              
              
              14Total
                  operating expenses
              
              
              58
              
              
              
              63
              
              
              
              61
              
              
              
              67Operating
                  income
              
              
              8
              
              
              
              7
              
              
              
              7
              
              
              
              6**Other
                  income (expense):**Interest
                  income, net
              
              
              1
              
              
              
              1
              
              
              
              1
              
              
              
              1Other
                  income (expense)
              
              
              --
              
              
              
              --
              
              
              
              --
              
              
              
              --Total
                  other income (expense)
              
              
              1
              
              
              
              1
              
              
              
              1
              
              
              
              1Income
                  before income taxes
              
              
              9
              
              
              
              8
              
              
              
              8
              
              
              
              7Income
                  tax benefit (expense)
              
              
              --
              
              
              
              22
              
              
              
              --
              
              
              
              8Net
                  income
              
              
              9
              %
              
              
              30
              %
              
              
              8
              %
              
              
              15
              %
 
  -
            17
            -
  **Comparison
        of Three and Nine Months Ended September 30, 2007 and 2006**
 
 ***Revenues***
 
 *Product
        Revenues*
 **Three
                    Months Ended**
                  **September
                    30,**
              
              
              **Nine
                    Months Ended**
                  **September
                    30,****2007**
              
              
              **2006**
              
              
              **2007**
              
              
              **2006****($
                  in thousands)**Product
                  revenues
              
              $
              15,032
              
              
              $
              11,967
              
              
              $
              41,740
              
              
              $
              30,414Change
                  from prior year period
              
              
              26
              %
              
              
              54
              %
              
              
              37
              %
              
              
              25
              %Percentage
                  of total revenues
              
              
              52
              %
              
              
              54
              %
              
              
              52
              %
              
              
              51
              %
 
 Product
        revenues, which include software and hardware revenues, increased during
        the
        three and nine months ended September 30, 2007 compared to the same periods
        in
        2006 across all major geographies. During the quarter and nine months, we
        recognized increased hardware revenues, which was primarily due to a higher
        demand for our media server and gateway appliances which have added to the
        scalability and functionality of our solutions. During the nine months ended
        September 30, 2007, we have experienced increases in orders greater than
        $100,000 and increases in orders from our existing customer base compared
        to the
        same period in 2006.
 
 *Services
        Revenues*
 **Three
                    Months Ended**
                  **September
                    30,**
              
              
              **Nine
                    Months Ended**
                  **September
                    30,****2007**
              
              
              **2006**
              
              
              **2007**
              
              
              **2006****($
                  in thousands)**Services
                  revenues
              
              $
              13,676
              
              
              $
              10,030
              
              
              $
              38,141
              
              
              $
              28,766Change
                  from prior year period
              
              
              36
              %
              
              
              35
              %
              
              
              33
              %
              
              
              36
              %Percentage
                  of total revenues
              
              
              48
              %
              
              
              46
              %
              
              
              48
              %
              
              
              49
              %
 
 Services
        revenues include the portion
        of the initial license arrangement allocated to maintenance and support revenues
        from annually renewable and perpetual contracts, license renewals of annually
        renewable contracts, and support fees for perpetual contracts, as well as
        professional services, education and other miscellaneous
        revenues.
 
 The
        increase during the three and nine months ended September 30, 2007 compared
        to
        the same periods in 2006 was primarily due to our growing installed base
        of
        customers and related payments of annual license renewal fees and support
        fees
        for perpetual licenses. License renewal and support revenues increased by
        $1.8
        million and $4.9 million during the three and nine months ended September
        30,
        2007, respectively, or 22% and 21%, respectively, compared to the same periods
        in 2006. As new customers license our solutions, we expect that our services
        revenues will increase as these customers continue to renew their licenses
        and
        pay for ongoing support for our solutions.
 
 During
        the three and nine months ended September 30, 2007, revenues from professional
        services increased $1.6 million and $3.8 million, respectively, from the
        same
        periods in 2006 due to more of our larger, direct customers utilizing our
        professional services group to assist in implementing our
        solutions.  In April 2007, we acquired the professional services
        division of Alliance, which added 13 engineers to our professional services
        group and increased our resources to serve our customers. We anticipate these
        revenues related to professional services will continue to increase in the
        future if the number of our large, direct customers continues to
        grow.
 
  -
            18
            -
  Educational
        and other services revenues increased $278,000 and $605,000 for the three
        and
        nine months ended September 30, 2007, respectively, compared to the same
        periods
        in 2006. These revenues have and will fluctuate based on the number of customers
        and partners that attend our educational classes, and the amount of assistance
        our customers and partners need for implementation and
        installation.
  ***Cost
        of
        Revenues***
 **Three
                    Months Ended**
                  **September
                    30,**
              
              
              **Nine
                    Months Ended**
                  **September
                    30,****2007**
              
              
              **2006**
              
              
              **2007**
              
              
              **2006****($
                  in thousands)**Cost
                  of revenues:Product
              
              $
              4,232
              
              
              $
              2,707
              
              
              $
              10,173
              
              
              $
              6,073Services
              
              
              5,533
              
              
              
              3,828
              
              
              
              15,475
              
              
              
              10,121Total
                  cost of revenues
              
              $
              9,765
              
              
              $
              6,535
              
              
              $
              25,648
              
              
              $
              16,194Change
                  from prior year period
              
              
              49
              %
              
              
              76
              %
              
              
              58
              %
              
              
              47
              %Product
                  costs as a % of product revenues
              
              
              28
              %
              
              
              23
              %
              
              
              24
              %
              
              
              20
              %Services
                  costs as a % of services revenues
              
              
              40
              %
              
              
              38
              %
              
              
              41
              %
              
              
              35
              %
 
 Costs
        of product consist of hardware
        costs, principally for appliances which we have developed, servers, telephone
        handsets and gateways, royalties for third party software and other technologies
        included in our solutions and, to a lesser extent, software packaging costs,
        which include product media, duplication and documentation. Costs of product
        can
        fluctuate depending on which software applications are licensed to our
        customers, the third party software, if any, which is licensed by the end
        user
        from us as part of our software applications and the dollar amount of orders
        for
        hardware.
 
 Costs
        of
        product increased $1.5 million or 56% and $4.1 million or 68% during the
        three
        and nine months ended September 30, 2007, respectively, compared to the same
        periods in 2006.  Hardware costs represented $1.0 million and $2.1
        million of the increase during the three and nine months ended September
        30,
        2007, respectively, compared to the same periods in 2006.  Royalties
        paid to third parties increased $295,000 and $1.5 million during the three
        and
        nine months ended September 30, 2007, respectively, compared to the same
        periods
        in 2006, as we licensed more third party software. In addition, we also
        increased staffing in our distribution center during 2007 compared to 2006,
        which resulted in our compensation expense increasing $121,000 and $316,000
        for
        the three and nine months ended September 30, 2007, respectively.
 
 Costs
        of
        services consist primarily of compensation expenses for technical support,
        educational and professional services personnel and other costs associated
        with
        supporting our partners and customers. These expenses increased during the
        three
        and nine months ended September 30, 2007, as compared to the same periods
        in
        2006, primarily due to a $1.4 million and $3.8 million increase in compensation
        expense, respectively, as a result of a 35% staffing increase in our services
        personnel at September 30, 2007 compared to September 30, 2006. As a result
        of
        the increased professional services activity, travel related expenses increased
        $107,000 and $331,000 for the three and nine months ended September 30, 2007,
        respectively, compared to the same periods in 2006.  During 2007, we
        experienced more demand for our professional services personnel to implement
        our
        solutions at our customers’ sites, which resulted in additional costs of
        $352,000 related to contracting outsourced professionals for the nine months
        ended September 30, 2007 compared to 2006. In the second quarter of 2007,
        we
        acquired the professional services division of Alliance, which added 13
        engineers to our professional services group and contributed significantly
        to
        our increased compensation expenses in the second and third quarters of
        2007.
 
 We
        anticipate these costs will continue to increase if the number of our large,
        direct customers continues to grow.
 
 ***Gross
        Profit***
 **Three
                    Months Ended**
                  **September
                    30,**
              
              
              **Nine
                    Months Ended**
                  **September
                    30,****2007**
              
              
              **2006**
              
              
              **2007**
              
              
              **2006****($
                  in thousands)**Gross
                  profit
              
              $
              18,943
              
              
              $
              15,462
              
              
              $
              54,233
              
              
              $
              42,986Change
                  from prior year period
              
              
              23
              %
              
              
              35
              %
              
              
              26
              %
              
              
              25
              %Percentage
                  of total revenues
              
              
              66
              %
              
              
              70
              %
              
              
              68
              %
              
              
              73
              %
 
 Gross
        profit as a percentage of total revenues decreased during the three and nine
        months ended September 30, 2007 compared to the same periods in 2006, primarily
        due to additional costs of products and services as discussed previously.
        The
        gross margin on our hardware sales is less than the gross margin on our software
        licenses; therefore, as we continue to sell more hardware, our total gross
        margin percentage may decrease compared to historical margins. Gross margin
        in
        any particular quarter is dependent upon revenues recognized versus costs
        of
        product and costs of services incurred and is expected to vary.
  -
            19
            -
  
 ***Operating
        Expenses***
  *Sales
        and
        Marketing*
 **Three
                    Months Ended**
                  **September
                    30,**
              
              
              **Nine
                    Months Ended**
                  **September
                    30,****2007**
              
              
              **2006**
              
              
              **2007**
              
              
              **2006****($
                  in thousands)**Sales
                  and marketing expenses
              
              $
              9,231
              
              
              $
              7,535
              
              
              $
              26,680
              
              
              $
              21,283Change
                  from prior year period
              
              
              23
              %
              
              
              22
              %
              
              
              25
              %
              
              
              17
              %Percentage
                  of total revenues
              
              
              32
              %
              
              
              34
              %
              
              
              33
              %
              
              
              36
              %Percentage
                  of net product revenues
              
              
              85
              %
              
              
              81
              %
              
              
              85
              %
              
              
              87
              %
 
 Sales
        and
        marketing expenses are comprised primarily of compensation expenses, travel
        and
        entertainment expenses and promotional costs related to our sales, marketing,
        and channel management operations. Compensation expense increased $1.3 million
        during the three months ended September 30, 2007, which was due in part to
        a 17%
        staffing increase in our sales and marketing personnel at September 30, 2007
        compared to September 30, 2006. Also contributing to the increase in
        compensation expense was an increase of $500,000 for commission expense during
        the third quarter of 2007, which was primarily related to the increase in
        product gross profit and increases in commissionable services during those
        periods.  We also incurred $255,000 of additional costs as a result of
        increased marketing events and other activities. Depreciation expense increased
        $101,000 during the quarter primarily due to leasehold improvements in several
        new sales and marketing offices. These additional expenses during the three
        months ended September 30, 2007 were offset by a decrease of $176,000 in
        partner
        referral fees.
 
 During
        the nine months ended September 30, 2007, compensation expense increased
        $3.7
        million due to the staffing increase in sales and marketing personnel as
        mentioned previously and also included a lump sum severance payment we made
        to a
        former executive officer of $175,000. Also contributing to the increase in
        compensation expense was an increase of $1.0 million for commission expense
        during the first nine months of 2007, which was related to the increase in
        product gross profit and increases in commissionable services.  We
        also incurred an increase of $480,000 related to increased marketing events
        and
        other activities, an increase of $277,000 for travel related expenses, and
        an
        increase of $187,000 related to depreciation expense primarily due to leasehold
        improvements in several new sales and marketing offices.  These
        additional expenses during the nine months ended September 30, 2007 were
        primarily offset by a decrease of $114,000 in partner sales referral fees
        as
        more partner referral fees were paid to partners during the first nine months
        of
        2006 than in the related period in 2007.
 
 Sales
        and
        marketing expenses as a percentage of total revenues and as a percentage
        of net
        product revenues can fluctuate during any period based on changes in sales
        and
        marketing expenses and gross profit margins.
 
 *Research
        and
        Development*
 **Three
                    Months Ended**
                  **September
                    30,**
              
              
              **Nine
                    Months Ended**
                  **September
                    30,****2007**
              
              
              **2006**
              
              
              **2007**
              
              
              **2006****($
                  in thousands)**Research
                  and development expenses
              
              $
              4,348
              
              
              $
              3,519
              
              
              $
              12,472
              
              
              $
              9,933Change
                  from prior year period
              
              
              24
              %
              
              
              15
              %
              
              
              26
              %
              
              
              5
              %Percentage
                  of total revenues
              
              
              15
              %
              
              
              16
              %
              
              
              16
              %
              
              
              17
              %
 
 Research
        and development expenses are comprised primarily of compensation and
        depreciation expenses. Research and development expenses increased during
        the
        three and nine months ended September 30, 2007, as compared to the same periods
        in 2006, primarily due to an increase in compensation expense of $765,000
        and
        $2.1 million, respectively, as a result of a 24% staffing increase in our
        research and development personnel at September 30, 2007 compared to September
        30, 2006. In addition, we incurred incremental research and development costs
        of
        $250,000 during the nine months ended September 30, 2007, which were related
        to
        increases in depreciation expense, recruiting and consulting
        fees.
  -
            20
            -
  
 *General
        and
        Administrative*
 **Three
                    Months Ended**
                  **September
                    30,**
              
              
              **Nine
                    Months Ended**
                  **September
                    30,****2007**
              
              
              **2006**
              
              
              **2007**
              
              
              **2006****($
                  in thousands)**General
                  and administrative expenses
              
              $
              3,310
              
              
              $
              2,739
              
              
              $
              9,660
              
              
              $
              8,106Change
                  from prior year period
              
              
              21
              %
              
              
              27
              %
              
              
              19
              %
              
              
              31
              %Percentage
                  of total revenues
              
              
              11
              %
              
              
              13
              %
              
              
              12
              %
              
              
              14
              %
 
 General
        and administrative expenses are comprised of compensation expense and general
        corporate expenses that are not allocable to other departments including
        legal
        and other professional fees and bad debt expense. General and administrative
        expenses increased during the three and nine months ended September 30, 2007,
        as
        compared to the same periods in 2006, primarily due to an increase in
        compensation expense of $370,000 and $856,000, respectively, as a result
        of a
        25% staffing increase in our general and administrative personnel at September
        30, 2007 compared to September 30, 2006. For the nine months ended September
        30,
        2007, we also incurred an increase of $153,000 of higher professional services
        expenses primarily related to accounting and legal fees.
 
 ***Other
        Income (Expense)***
  *Interest
        Income, Net*
 **Three
                  Months Ended**
                **September
                  30,**
              
              
              **Nine
                  Months Ended**
                **September
                  30,****2007**
              
              
              **2006**
              
              
              **2007**
              
              
              **2006****($
                  in thousands)**Cash,
                  cash equivalents and short-term investments (average)
              
              $
              33,261
              
              
              $
              21,255
              
              
              $
              30,733
              
              
              $
              18,734Interest
                  income
              
              
              412
              
              
              
              201
              
              
              
              1,268
              
              
              
              430Return
                  on investment (annualized)
              
              
              5.0
              %
              
              
              3.8
              %
              
              
              5.5
              %
              
              
              3.1
              %
 
 Interest
        income, net is primarily comprised of interest earned from investments and
        interest-bearing cash accounts. Interest expense and fees in 2006, which
        were
        not material, were also included in interest income, net. Interest earned
        on
        investments improved during the three and nine months ended September 30,
        2007,
        compared to the same periods in 2006, due primarily to increasing cash and
        investment balances, better monitoring of funds in which we have invested
        to
        increase our return on investment and higher interest rates and lower
        fees.
  *Other
        Income (Expense),
        Net*
 **Three
                  Months Ended**
                **September
                  30,**
              
              
              **Nine
                  Months Ended**
                **September
                  30,****2007**
              
              
              **2006**
              
              
              **2007**
              
              
              **2006****($
                  in thousands)**Other
                  income (expense)
              
              $
              29
              
              
              $
              (25
              )
              
              $
              (69
              )
              
              $
              (89
              )
 
 Other
          expense, net includes foreign currency transaction gains and losses, as
          well as
          foreign tax withholdings. These amounts depend on the amount of revenue
          that is
          generated in certain international currencies, particularly the Euro, and
          the
          exchange gain or loss that results from foreign currency disbursements
          and
          receipts. The other income recognized during the three months ended September
          30, 2007 and the decrease in other expense recognized during the first
          nine
          months of 2007, compared to the same periods in 2006, was primarily due
          to an
          increase in foreign exchange gains realized and a decrease in foreign tax
          withholdings compared to the same periods in 2006.
  -
            21
            -
  **Liquidity
        and Capital Resources**
  We
        generate cash from the collections we receive related to licensing our contact
        center and IP-PBX applications and from annual license renewals, maintenance
        and
        support and other services revenues. We also had in place an unused $3.0
        million
        line of credit as of September 30, 2007, that subsequently expired on October
        31, 2007. We did not renew our line and will consider obtaining a new line
        in
        the future. We use cash primarily for paying our employees (including salaries,
        commissions and benefits), leasing office space, paying travel expenses,
        marketing activities, paying vendors for other services and supplies and
        purchasing property and equipment.
 
 We
        determine liquidity by combining cash and cash equivalents and short-term
        investments as shown in the table below. Our total liquidity position as
        of
        September 30, 2007 improved compared with our position as of December 31,
        2006
        due mainly to increased net income, increasing deferred revenue balances
        and
        increased cash collections. We believe that our current liquidity position,
        when
        combined with our anticipated cash flows from operations, will be sufficient
        to
        satisfy our operating cash needs over the next 12 months. If cash flows from
        operations are less than anticipated or we have additional cash needs (such
        as
        an unfavorable outcome in legal proceedings), our liquidity may not be
        sufficient to cover our needs. In this case, we may be forced to raise
        additional capital, either through the capital markets or debt financings.
        We
        may not be able to receive favorable terms in raising this capital.
 
 **September
                  30,**
              
              
              **December
                  31,****2007**
              
              
              **2006****($
                  in thousands)**Cash
                  and cash equivalents
              
              $
              23,430
              
              
              $
              13,531Short-term
                  investments
              
              
              10,949
              
              
              
              13,555Liquidity,
                  net
              
              $
              34,379
              
              
              $
              27,086
 
 Our
        operating activities resulted in net cash provided of $9.8 million and $6.6
        million for the nine months ended September 30, 2007 and 2006, respectively.
        The
        $3.2 million of additional net cash provided was primarily a result of net
        income and higher deferred revenues offset by an increasing accounts receivables
        balance.
 
 The
        amount that we report as cash and cash equivalents or as temporary investments
        fluctuates depending on investing decisions in each period. Purchases of
        short-term investments are reported as a use of cash and the related receipt
        of
        proceeds upon maturity of the investment is reported as a source of
        cash.
 
 Net
        cash
        used in investing activities was $1.7 million and $7.6 million for the nine
        months ended September 30, 2007 and 2006, respectively. During the second
        quarter of 2007, we used $853,000 of cash from operations to acquire the
        professional services division of Alliance. In addition, during July 2007
        we
        paid $180,000 to Alliance related to a hold back provision that was owed
        as part
        of the asset purchase agreement. During the nine months ended September 30,
        2007, we purchased $4.3 million of additional available-for-sale investments;
        however these additional purchases were offset by $12.9 million of additional
        available-for-sale investments that matured during the first nine months
        of 2007
        compared to the same period in 2006. We also purchased property and equipment
        totaling $3.6 million during the first nine months of 2007 compared to $1.9
        million during the same period in 2006. These purchases related mainly to
        hardware and leasehold improvements for our corporate headquarters and regional
        offices. As our operations continue to grow and we add new employees, we
        anticipate that our purchases of property and equipment will continue to
        increase in future periods.
 
 Net
        cash
        provided by financing activities was $1.8 million and $2.4 million for the
        nine
        months ended September 30, 2007 and 2006, respectively. The decrease in cash
        provided was mainly due to lower proceeds from stock options that were exercised
        during the nine months ended September 30, 2007.
 
 During
        the second quarter of 2007, we entered into an amendment of our corporate
        office
        operating lease under which the current leased space will be expanded to
        an
        office building currently under construction and adjacent to our corporate
        headquarters. The rent for the additional space through the lease expiration
        date will be approximately $16.3 million, payable in pro-rata monthly
        installments, as defined in the amendment and will commence as we utilize
        the
        additional space, which is expected to be no earlier than March 1, 2008. In
        consideration for entering into the amendment, the landlord agreed to pay
        us a
        discretionary allowance of $450,000 which is payable as we utilize the
        additional space in the office building. We intend to use this allowance
        for
        certain costs associated with our corporate headquarters and/or the additional
        space, as defined in the amendment. This amendment did not have any financial
        statement impact, and there were no material changes related to this amendment,
        during the quarter ended September 30, 2007.
 
 On
        October 17, 2007, October 23, 2007, and October 26, 2007, we filed separately
        with the SEC the first, second and third amendments, respectively, to the
        registration statement on Form S-3 utilizing the “shelf” registration process,
        which was originally filed on October 19, 2006. This registration statement,
        as
        amended, was declared effective by the SEC on October 31, 2007 and will allow
        us
        to offer and sell up to 3,000,000 shares of our common stock from time to
        time
        in one or more transactions. In addition, under this shelf registration
        statement, as amended, Dr. Donald E. Brown, our Chairman of the Board, President
        and CEO, registered 1,000,000 shares of our common stock that he owns for
        sale
        from time to time. Although the shelf registration statement, as amended,
        will
        permit us to offer and sell up to 3,000,000 shares of our common stock, doing
        so
        remains at the discretion of our Board of Directors, and there is no assurance
        that we would be able to complete any such offering of our common
        stock.
 
  -
            22
            -
  As
        of
        September 30, 2007, there have been no material changes in our contractual
        obligations as set forth in the Contractual Obligations table disclosed in
        our
        Annual Report on Form 10-K for the year ended December 31, 2006, as supplemented
        by the Contractual Obligations table disclosed in our Quarterly Reports on
        Form
        10-Q for the periods ended March 31, 2007 and June 30, 2007.
 
 **Off-Balance
        Sheet Arrangements**
 
 Except
        as
        set forth in the Contractual Obligations table disclosed in our Annual Report
        on
        Form 10-K for the year ended December 31, 2006, as supplemented by the
        Contractual Obligations table disclosed in our Quarterly Reports on Form
        10-Q
        for the periods ended March 31, 2007 and June 30, 2007, we have no off-balance
        sheet arrangements that have or are reasonably likely to have a current or
        future material impact on our financial condition, changes in financial
        condition, revenues or expenses, results of operations, liquidity, capital
        expenditures or capital resources as of September 30, 2007.
 
 **Critical
        Accounting Policies and Estimates**
  We
        believe the accounting policies listed below are important to understanding
        our
        historical and future performance, as these policies affect the reported
        amounts
        of revenues and income and are the more significant areas involving management’s
        judgments and estimates. These policies, and our procedures related to these
        policies, are described below. See also Note 2 of Notes to Consolidated
        Financial Statements included in our Annual Report on Form 10-K for the year
        ended December 31, 2006 for a further summary of our other significant
        accounting policies.
 
 ***Sources
        of Revenues and Revenue Recognition Policy***
 
 We
        generate product revenues from licensing the right to use our software
        applications and in certain instances providing hardware as a component of
        our
        solution, and we generate services revenues primarily from annual support
        fees,
        annual renewal fees, professional services and educational
        services.
 
 *Product
        Revenues*
 
 Our
        license agreements are either perpetual or annually renewable.  For
        any revenues to be recognized from a license agreement, the following criteria
        must be met:
 
 ·
              Persuasive
                  evidence of an arrangement exists;
 
 ·
              The
                  fee is fixed or determinable;
 
 ·
              Collection
                  is probable; and
 
 ·
              Delivery
                  has occurred.
 
 For
        a
        perpetual license agreement, upon meeting the revenue recognition criteria
        above, we immediately recognize as product revenues the amount of initial
        license fees if sufficient vendor specific objective evidence of fair value
        (“VSOE”) exists to support allocating a portion of the total fee to the
        undelivered elements of the arrangement. If sufficient VSOE of the undelivered
        elements does not exist, we recognize the initial license fee as product
        revenues ratably over the initial term of the support agreement once support
        is
        the only undelivered element. The support period is generally 12 months but
        may
        be up to 18 months for initial orders because support begins when the licenses
        are downloaded, when support commences, or no more than six months following
        the
        contract date. We determine VSOE of support in perpetual agreements based
        on
        substantive renewal rates the customer must pay to renew the support. The
        VSOE
        of other services is based on amounts charged when the services are sold
        in
        stand-alone sales.
 
 For
        an
        annually renewable license agreement, upon meeting the revenue recognition
        criteria above, we recognize a majority of the initial license fees under
        these
        agreements as product revenues ratably over the initial license period, which
        is
        generally 12 months, and the remainder of the initial license fees are
        recognized as services revenues over the same time period.
 
 We
        recognize revenues related to any hardware sales when the hardware is delivered
        and all other revenue recognition criteria are met.
 
 *Services
        Revenues*
 
 Services
        revenues are primarily recognized for renewal fees and support related to
        annually renewable license agreements and support fees for perpetual license
        agreements. For annually renewable agreements, the allocation of the initial
        order between product revenues and services revenues is based on the average
        renewal rates of all time based contracts. We apply the allocation of product
        revenues and services revenues consistently to all annually renewable
        agreements. Under annually renewable license agreements, after the initial
        license period, our customers may renew their license agreement for an
        additional period, typically 12 months, by paying a renewal fee. The revenue
        for
        the annual renewal fees are all classified under services revenue and the
        revenue is recognized ratably over the contract period. Under perpetual license
        agreements, we recognize annual support fees as services revenues ratably
        over
        the post-contract support period, which is typically 12 months.
 
  -
            23
            -
  We
        also
        generate revenues from other services that we provide to our partners and
        customers. These additional revenues include fees for professional services
        and
        educational services. Revenues from professional services, which include
        implementing our products for a customer, and educational services, which
        consist of training courses for partners and customers, are recognized as
        the
        related services are performed.
 
 ***Stock-Based
        Compensation Expense***
 
 We
        account for our employee and director stock options in accordance with SFAS
        123R
        and the guidance of SAB 107, which requires the measurement and recognition
        of
        compensation expense for all share-based payment awards made to employees
        and
        directors, based on fair values.  As permitted by SFAS 123R, we
        continued to use the Black-Scholes option-pricing model as our method of
        valuation for share-based payment awards. Our determination of fair value
        of
        share-based payment awards on the date of grant using an option-pricing model
        is
        affected by our stock price as well as assumptions regarding a number of
        highly
        complex and subjective variables. These variables include, but are not limited
        to, our expected stock price volatility over the term of the awards and an
        expected risk-free rate of return. If factors change and we use different
        assumptions for estimating stock-based compensation expense in future periods,
        stock-based compensation expense may differ materially in the future from
        that
        recorded in the current period.
 
 Stock-based
        compensation expense for employee stock options recognized under SFAS 123R
        for
        the three and nine months ended September 30, 2007 was $812,000 and $2.3
        million, respectively, compared to $451,000 and $1.6 million, respectively,
        during the same periods in 2006.
 
 ***Income
        Taxes***
 
 Income
        taxes are accounted for under the asset and liability method. Deferred tax
        assets and liabilities are recognized for the future tax consequences
        attributable to differences between the financial statement carrying amounts
        of
        existing assets and liabilities and their respective tax bases and operating
        loss and tax credit carry-forwards. Deferred tax assets and liabilities are
        measured using enacted tax rates expected to apply to taxable income in the
        years in which those temporary differences are expected to be recovered or
        settled. The effect on deferred tax assets and liabilities of a change in
        tax
        rates is recognized in income in the period that includes the enactment
        date.
 
 SFAS
        No.
        109, *Accounting for Income Taxes*, establishes financial accounting and
        reporting standards for the effect of income taxes. We are subject to income
        taxes in both the United States and numerous foreign jurisdictions. Significant
        judgment is required in evaluating our tax positions and determining our
        provision for income taxes. The objectives of accounting for income taxes
        are to
        recognize the amount of taxes payable or refundable for the current year
        and
        deferred tax liabilities and assets for the future tax consequences of events
        that have been recognized in an entity’s financial statements or tax returns.
        Variations in the actual outcome of these future tax consequences could
        materially impact our financial position, results of operations, or cash
        flows.
 
 In
        assessing the recoverability of deferred tax assets, management considers
        whether it is more likely than not that some portion or all of the deferred
        tax
        assets will not be realized. The ultimate realization of deferred tax assets
        is
        dependent upon generation of future taxable income during the periods in
        which
        temporary differences become deductible. Management considers projected future
        taxable income and tax planning strategies in making this assessment and
        ensuring that the deferred tax asset valuation allowance is adjusted as
        appropriate.
 
 See
        Note
        7 of Notes to Condensed Consolidated Financial Statements for further
        information on our income taxes.
 
 ***Allowance
        for Doubtful Accounts Receivable***
 
 We
        evaluate bad debt expense based on a percentage of revenue reported each
        period.
        We review the allowance for doubtful accounts for each reporting period based
        on
        a detailed analysis of our accounts receivable to determine that the amount
        of
        the allowance for doubtful accounts receivable is appropriately stated at
        the
        end of that period. In the analysis of accounts receivable, we primarily
        consider the age of the partner’s or customer’s receivable and also consider the
        creditworthiness of the partner or customer, the economic conditions of the
        customer’s industry, and general economic conditions, among other factors. If
        payment is not made timely, we contact the customer or partner to try to
        obtain
        payment. If this is not successful, we institute other collection practices
        such
        as generating collection letters, involving our sales representatives and
        ultimately terminating the customer’s or partner’s access to future upgrades,
        licenses and customer support. Once all collection efforts are exhausted,
        the
        receivable is written off against the allowance for doubtful
        accounts.
 
  -
            24
            -
  ***Research
        and Development***
 
 Through
        September 30, 2007, all research and development expenditures have been expensed
        as incurred. Based on our product development process and technological
        feasibility, the date at which capitalization of development costs may begin
        is
        established upon completion of a working model. Costs incurred between
        completion of the working model and the point at which the product is ready
        for
        general release have been insignificant.
 
 ***Legal
        Proceedings***
 
 Liabilities
        for loss contingencies arising from claims, assessments, litigation, fines,
        and
        penalties and other sources are recorded when it is probable that a liability
        has been incurred and the amount of the assessment and/or remediation can
        be
        reasonably estimated. Legal costs incurred in connection with loss contingencies
        are expensed as incurred.
 
 **Item
                  3.**
              **Quantitative
                  and Qualitative Disclosures about Market
                  Risk.**
 
 We
        develop products in the United
        States and license our products in the Americas,Europe, the Middle
        East andAfrica andAsia/Pacific.
        As a result, our financial results
        could be affected by various factors, including changes in foreign currency
        exchange rates or weak economic conditions in foreign markets. As most sales
        are
        currently made in U.S. dollars, a strengthening of the dollar could make
        our
        products less competitive in foreign markets. Additionally, as our business
        matures in foreign markets, we may offer our products and services in certain
        other local currencies. As a result, we will be subject to foreign currency
        fluctuations, which may have an adverse affect on our
        company.
 
 We
        manage
        our interest rate risk by maintaining an investment portfolio with debt
        instruments of high credit quality and relatively short average maturities.
        We
        also manage interest rate risk by maintaining sufficient cash and cash
        equivalent balances such that we are typically able to hold our investments
        to
        maturity. Through October 31, 2007, we had a line of credit with a variable
        interest rate based upon the bank’s prime rate. We did not incur any interest
        expense on this line during the three and nine months ended September 30,
        2007
        and 2006.
 
 **Item
                  4.**
              **Controls
                  and Procedures.**
 
 We
        maintain a set of disclosure controls and procedures that are designed to
        ensure
        that information required to be disclosed by us in the reports filed by us
        under
        the Securities Exchange Act of 1934, as amended (the “Exchange Act”) is
        recorded, processed, summarized and reported within the time periods specified
        in the SEC’s rules and forms. We carried out an evaluation, under the
        supervision and with the participation of our management, including our
        President and Chief Executive Officer (principal executive officer) and our
        Chief Financial Officer (principal financial officer), of the effectiveness
        of
        the design and operation of our disclosure controls and procedures as of
        September 30, 2007 pursuant to Rule 13a-15(b) of the Exchange Act. Based
        on that
        evaluation, our principal executive officer and principal financial officer
        concluded that our disclosure controls and procedures were
        effective.
 
 There
        have been no changes in our internal control over financial reporting that
        occurred during the three months ended September 30, 2007 that have materially
        affected, or are reasonably likely to materially affect, our internal control
        over financial reporting.
 
 **PART
        II. OTHER INFORMATION**
 
 **Item
                  1.**
              **Legal
                  Proceedings.**
  The
        information set forth in Note 6 of Notes to Condensed Consolidated Financial
        Statements included in Part I, Item 1 of this report is incorporated herein
        by
        reference.
  **Item
                  1A.**
              **Risk
                  Factors.**
 
 In
        addition to the information set forth in this Report and before deciding
        to
        invest in, or retain, shares of our common stock, you also should carefully
        review and consider the information contained in our other reports and periodic
        filings that we make with the SEC, including, without limitation, the
        information contained under the caption Item 1A “Risk Factors” in our Annual
        Report on Form 10-K for the year ended December 31, 2006. Those risk factors
        could materially affect our business, financial condition and results of
        operations.
  The
        risks
        that we describe in our public filings are not the only risks that we face.
        Additional risks and uncertainties not currently known to us, or that we
        presently deem to be immaterial, also may materially adversely affect our
        business, financial condition and results of operations. During the three
        months
        ended September 30, 2007, there were no material changes from risk factors
        previously disclosed in our Annual Report on Form 10-K for the year ended
        December 31, 2006.
  -
            25
            -




**Item
                6.**
            **Exhibits.**





(a)
            Exhibits





3.1
            
            Restated
                Articles of Incorporation of the Company, as currently in effect
                (incorporated herein by reference from the same exhibit number to
                the
                Company’s Registration Statement on Form S-1 (Registration No.
                333-79509))3.2
            
            Amended
                By-Laws of the Company, as currently in effect (incorporated herein
                by
                reference from the same exhibit number to the Company’s Current Report on
                Form 8-K filed on August 21, 2007)


31.1
            
            Certification
                of the Chief Executive Officer pursuant to Rule 13a-14(a)/15d-14(a)
                of the
                Securities Exchange Act of 1934, as adopted pursuant to Section 302
                of the
                Sarbanes-Oxley Act of 200231.2
            
            Certification
                of the Chief Financial Officer pursuant to Rule 13a-14(a)/15d-14(a)
                of the
                Securities Exchange Act of 1934, as adopted pursuant to Section 302
                of the
                Sarbanes-Oxley Act of 200232.1
            
            Certification
                of the Chief Executive Officer, pursuant to 18 U. S. C. Section 1350,
                as
                adopted pursuant to Section 906 of the Sarbanes-Oxley Act of
                200232.2
            
            Certification
                of the Chief Financial Officer, pursuant to 18 U. S. C. Section 1350,
                as
                adopted pursuant to Section 906 of the Sarbanes-Oxley Act of
                2002








-
            26
            -





**SIGNATURES**




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




**Interactive
                Intelligence, Inc.**
              (Registrant)Date:   November
                2, 2007
            
            
            
            By:
            
            /s/
                    Stephen R.
                Head**Stephen
                R. Head**
              ***Chief
                Financial Officer,***
              ***Vice
                President of Finance and Administration,***
              ***Secretary
                and Treasurer***
              ***(Principal
                Financial Officer and Principal Accounting
                Officer)***












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