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 March 31, 2008
 
 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
  CORPORATE LOGO
 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)Not
      Applicable(Former
      name, former address and former fiscal year, if changed since last
      report)
 
 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. YesRNor
  Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filer, a non-accelerated filer, or a smaller reporting company. See
the definitions of “large accelerated filer,” “accelerated filer” and “smaller
reporting company” in Rule 12b-2 of the Exchange Act.(Check One):
  Large
      accelerated filer
              r
              
              Accelerated
      filer
              RNon-accelerated
      filer
              r(Do not
      check if a smaller reporting company)
              Smaller
      reporting company
              r
  Indicate by check mark whether the
registrant is a shell company (as defined in Rule 12b-2 of the Exchange
Act). Yes r No R
 
 As of
April 30, 2008, there were 17,966,531shares outstanding of the registrant’s common stock, $0.01 par
value.














TABLE
OF CONTENTS
  PART
      I. FINANCIAL INFORMATION
              PageItem
      1.
              Financial Statements.Condensed Consolidated Balance Sheets as of March 31, 2008 and
      December 31, 2007
              2Condensed Consolidated Statements of Income for the Three
      Months Ended March 31, 2008 and 2007
              3Condensed Consolidated Statement of Shareholders’ Equity for
      the Three Months Ended March 31, 2008
              4Condensed Consolidated Statements of Cash Flows for the Three
      Months Ended March 31, 2008 and 2007
              5Notes to Condensed Consolidated Financial
      Statements
              6Item
      2.
              Management’s Discussion and Analysis of Financial Condition
      and Results of Operations.
              12Item
      3.
              Quantitative and Qualitative Disclosures About Market
      Risk.
              19Item
      4.
              Controls and Procedures.
              19PART
      II. OTHER INFORMATIONItem
      1.
              Legal Proceedings.
              19Item
      1A.
              Risk Factors.
              19Item
      6.
              Exhibits.
              20SIGNATURES
              21






- 1
-




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 March 31, 2008 and December 31, 2007
 (In
thousands, except share and per share amounts)
  March
      31,
                    2008
                
                
                December
      31,
                    2007(unaudited)
                
                
                (Note
      1)AssetsCurrent
      assets:Cash
      and cash equivalents
                
                $
                36,972
                
                
                $
                29,270Short-term
      investments
                
                
                12,465
                
                
                
                17,057Accounts
      receivable, net of allowance for doubtful accounts of$1,262
      at March 31, 2008
                  and
      $1,076 at December 31, 2007
                
                
                27,373
                
                
                
                27,527Deferred
      tax assets, net
                
                
                5,833
                
                
                
                5,833Prepaid
      expenses
                
                
                6,283
                
                
                
                5,501Other
      current assets
                
                
                1,255
                
                
                
                1,414Total
      current assets
                
                
                90,181
                
                
                
                86,602Property
      and equipment, net
                
                
                9,197
                
                
                
                6,932Deferred
      tax assets, net
                
                
                6,699
                
                
                
                7,520Other
      assets, net
                
                
                2,352
                
                
                
                2,384Total
      assets
                
                $
                108,429
                
                
                $
                103,438Liabilities
      and Shareholders’ EquityCurrent
      liabilities:Accounts
      payable and accrued liabilities
                
                $
                11,942
                
                
                $
                9,594Accrued
      compensation and related expenses
                
                
                3,325
                
                
                
                4,381Deferred
      product revenues
                
                
                6,959
                
                
                
                6,843Deferred
      services revenues
                
                
                30,352
                
                
                
                28,711Total
      current liabilities
                
                
                52,578
                
                
                
                49,529Noncurrent
      deferred services revenues
                
                
                4,839
                
                
                
                5,290Total
      liabilities
                
                
                57,417
                
                
                
                54,819Commitments
      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;17,953,516
      issued and outstanding
                  at
      March 31, 2008and
      17,901,084 issued and outstanding at December 31, 2007
                
                
                180
                
                
                
                179Additional
      paid-in capital
                
                
                80,680
                
                
                
                79,405Accumulated
      deficit
                
                
                (29,848
                )
                
                
                (30,965
                )Total
      shareholders’ equity
                
                
                51,012
                
                
                
                48,619Total
      liabilities and shareholders’ equity
                
                $
                108,429
                
                
                $
                103,438
   See
Accompanying Notes to Condensed Consolidated Financial Statements
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Interactive Intelligence,
Inc.
 Condensed
Consolidated Statements of Income (unaudited)
 For
the Three Months Ended March 31, 2008 and 2007
 (In
thousands, except per share amounts)
  Three
      Months Ended
                  March
      31,2008
              
              
              2007Revenues:Product
              
              $
              14,845
              
              
              $
              12,356Services
              
              
              14,638
              
              
              
              11,932Total
      revenues
              
              
              29,483
              
              
              
              24,288Cost
      of revenues:Product
              
              
              3,130
              
              
              
              2,441Services
              
              
              5,897
              
              
              
              4,797Total
      cost of revenues
              
              
              9,027
              
              
              
              7,238Gross
      profit
              
              
              20,456
              
              
              
              17,050Operating
      expenses:Sales
      and marketing
              
              
              10,178
              
              
              
              8,654Research
      and development
              
              
              4,965
              
              
              
              3,897General
      and administrative
              
              
              3,827
              
              
              
              3,065Total
      operating expenses
              
              
              18,970
              
              
              
              15,616Operating
      income
              
              
              1,486
              
              
              
              1,434Other
      income (expense):Interest
      income, net
              
              
              459
              
              
              
              472Other
      income (expense), net
              
              
              97
              
              
              
              (56
              )Total
      other income, net
              
              
              556
              
              
              
              416Income
      before income taxes
              
              
              2,042
              
              
              
              1,850Income
      tax expense
              
              
              (925
              )
              
              
              (97
              )Net
      income
              
              $
              1,117
              
              
              $
              1,753Net
      income per share:Basic
              
              $
              0.06
              
              
              $
              0.10Diluted
              
              
              0.06
              
              
              
              0.09Shares
      used to compute net income per share:Basic
              
              
              17,940
              
              
              
              17,247Diluted
              
              
              19,216
              
              
              
              19,236
   See
Accompanying Notes to Condensed Consolidated Financial Statements
  - 3
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Interactive Intelligence, Inc.
 Condensed
Consolidated Statement of Shareholders’ Equity (unaudited)
 For
the Three Months Ended March 31, 2008
 (In
thousands)
  Common
      StockShares
              
              Amount
              
              AdditionalPaid-in Capital
              
              Accumulated
                Deficit
              
              TotalBalances,
      December 31, 2007
              
              17,901
              
              $
              179
              
              $
              79,405
              
              $
              (30,965
              )
              $
              48,619Issuances
      of common stock
              
              2
              
              
              --
              
              
              62
              
              
              --
              
              
              62Exercise
      of stock options
              
              50
              
              
              1
              
              
              281
              
              
              --
              
              
              282Stock-based
      compensation
              
              --
              
              
              --
              
              
              932
              
              
              --
              
              
              932Net
      income
              
              --
              
              
              --
              
              
              --
              
              
              1,117
              
              
              1,117Balances,
      March 31, 2008
              
              17,953
              
              $
              180
              
              $
              80,680
              
              $
              (29,848
              )
              $
              51,012






See
Accompanying Notes to Condensed Consolidated Financial Statements




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Interactive Intelligence, Inc.
 Condensed
Consolidated Statements of Cash Flows (unaudited)
 For
the Three Months Ended March 31, 2008 and 2007
 (In
thousands)
   Three
      Months Ended
                March
      31,2008
              
              
              2007Operating
      activities:Net
      income
              
              $
              1,117
              
              
              $
              1,753Adjustments
      to reconcile net income to net cash provided by operating
      activities:Depreciation
              
              
              795
              
              
              
              573Accretion
      of investment income
              
              
              (4
              )
              
              
              (153
              )Stock-based
      compensation expense related to stock options
              
              
              932
              
              
              
              668Deferred
      income tax
              
              
              821
              
              
              
              --Changes
      in operating assets and liabilities:Accounts
      receivable
              
              
              154
              
              
              
              2,792Prepaid
      expenses
              
              
              (782
              )
              
              
              (272
              )Other
      current assets
              
              
              159
              
              
              
              (518
              )Other
      assets
              
              
              32
              
              
              
              6Accounts
      payable and accrued liabilities
              
              
              1,871
              
              
              
              102Accrued
      compensation and related expenses
              
              
              (1,056
              )
              
              
              (933
              )Deferred
      product revenues
              
              
              116
              
              
              
              (345
              )Deferred
      services revenues
              
              
              1,190
              
              
              
              1,185Net
      cash provided by operating activities
              
              
              5,345
              
              
              
              4,858Investing
      activities:Sales
      of available-for-sale investments
              
              
              11,200
              
              
              
              8,165Purchases
      of available-for-sale investments
              
              
              (6,604
              )
              
              
              (3,454
              )Purchases
      of property and equipment
              
              
              (2,583
              )
              
              
              (1,308
              )Net
      cash provided by investing activities
              
              
              2,013
              
              
              
              3,403Financing
      activities:Proceeds
      from stock options exercised
              
              
              282
              
              
              
              674Proceeds
      from issuance of common stock
              
              
              62
              
              
              
              50Net
      cash provided by financing activities
              
              
              344
              
              
              
              724Net
      increase in cash and cash equivalents
              
              
              7,702
              
              
              
              8,985Cash
      and cash equivalents, beginning of period
              
              
              29,270
              
              
              
              13,531Cash
      and cash equivalents, end of period
              
              $
              36,972
              
              
              $
              22,516Cash
      paid during the period for:Income
      taxes
              
              $
              128
              
              
              $
              27Other
      non-cash item:Purchases
      of property and equipment payable at end of period
              
              $
              (477
              )
              
              $
              --
   See
Accompanying Notes to Condensed Consolidated Financial Statements
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Interactive Intelligence, Inc.
 Notes
to Condensed Consolidated Financial Statements
 March
31, 2008 and 2007 (unaudited)
  1.
                FINANCIAL
      STATEMENT PRESENTATION
  The
accompanying unaudited condensed consolidated financial statements of
Interactive Intelligence, Inc. (the “Company”) have been prepared in conformity
with accounting principles generally accepted in the United States of America
(“US GAAP”) and with the instructions for Form 10-Q and Article 10 of Regulation
S-X for interim financial information. Accordingly, certain information and
footnote disclosures normally included in the Company’s financial statements
prepared in accordance with US GAAP have been condensed, or omitted, pursuant to
the rules and regulations of the United States Securities and Exchange
Commission (the “SEC”).
 
 The
preparation of the Company’s condensed consolidated financial statements
requires management to make estimates and assumptions that affect reported
amounts of assets and liabilities, at the respective balance sheet dates, and
the reported amounts of revenues and expenses during the respective reporting
periods.  Despite management’s best effort to establish good faith
estimates and assumptions, actual results could differ from these estimates. In
management’s opinion, the Company’s accompanying 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
Company’s accompanying condensed consolidated balance sheet as of December 31,
2007 has been derived from the Company’s audited consolidated financial
statements at that date but does not include all of the information and
footnotes required by US GAAP for complete financial statements. As a result,
these accompanying condensed consolidated financial statements should be read in
conjunction with the Company’s audited consolidated financial statements for the
year ended December 31, 2007, included in the Company’s most recent Annual
Report on Form 10-K as filed with the SEC on March 17, 2008. The Company’s
results of operations for any interim period are not necessarily indicative of
the results of operations for any other interim period or for a full fiscal
year.
 
 Principles
of Consolidation
 
 The
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.
 
 Reclassifications
and Adjustments
 
 Certain
reclassifications and adjustments have been made to prior year amounts to
conform to the current period presentation.
  Effective
March 31, 2008, in order to properly classify noncurrent deferred revenues from
the current portion, the Company reclassified its noncurrent deferred revenues
to a separate line item on the accompanying condensed consolidated balance
sheets.  In addition, the related prepaid commissions associated with
the Company’s noncurrent deferred revenues have also been appropriately
reclassified from the current portion of prepaid expenses and included in
noncurrent other assets, net. This reclassification did not have any impact on
results previously reported.
  During
the fourth quarter of 2007, the Company identified an error that affected
amounts previously reported on its Quarterly Reports on Form 10-Q for the first
three 2007 quarterly periods.  During the first three 2007 quarterly
periods, the Company deferred maintenance and support revenues based on an
assumed 18 month maintenance and support period but in certain cases, the actual
support period was less than the maximum period.  With respect to the
three months ended March 31, 2007, the Company under-recognized product revenues
in the amount of $95,000 and related commission expenses during the same period
was also under-recognized by $10,000.  This error did not have a
material impact on results previously reported.
  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.
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  Interactive Intelligence, Inc.
 Notes
to Condensed Consolidated Financial Statements (continued)
 2.
                SUMMARY
      OF CERTAIN ACCOUNTING POLICIES AND RECENT ACCOUNTING
      PRONOUNCEMENTS
 
 The
Company’s interim critical accounting policies and estimates include the
recognition of income taxes using an estimated annual effective tax
rate.  For a complete summary of the Company’s other significant
accounting policies and other critical accounting estimates, refer to Note 2 of
Notes to Consolidated Financial Statements included in the Company’s Annual
Report on Form 10-K for the year ended December 31, 2007.
 
 During
the three months ended March 31, 2008, there were no material changes to the
Company’s significant accounting policies or critical accounting estimates other
than the recent accounting pronouncements discussed below.
 
 In
December 2007, the Financial Accounting Standards Board (“FASB”) issued
Statement of Financial Accounting Standards (“SFAS”) No. 141 (revised 2007),
Business Combinations(“SFAS 141R”) and SFAS No. 160, Noncontrolling Interests in
Consolidated Financial Statements– an amendment to ARB No. 51(“SFAS
160”). SFAS 141R and SFAS 160 require most identifiable assets, liabilities,
noncontrolling interests, and goodwill acquired in a business combination to be
recorded at “full fair value” and require noncontrolling interests (previously
referred to as minority interests) to be reported as a component of equity,
which changes the accounting for transactions with noncontrolling interest
holders. Both SFAS 141R and SFAS 160 are effective for periods beginning on
or after December 15, 2008, and earlier adoption is prohibited. SFAS 141R will
be applied to business combinations occurring after the effective date. SFAS 160
will be applied prospectively to all noncontrolling interests, including any
that arose before the effective date. The Company does not expect that the
adoption of SFAS 141R and SFAS 160 will have a material impact on its
results of operations and financial position.
 
 In
December 2007, the SEC released Staff Accounting Bulletin (“SAB”) No. 110,
Share-Based Payment
(“SAB 110”), an amendment of SAB No. 107, which extended the permissibility of
the simplified method for calculating expected terms for options granted after
December 31, 2007. SAB 110 became effective for the Company beginning
January 1, 2008. The Company has determined that due to a change in the life of
its options from ten years to six years, it currently does not have sufficient
historical data to support using a method to determine the expected term of
options to be outstanding other than the simplified method.  The
Company will continue to monitor its use of the simplified method quarterly to
determine if it is appropriate.
 
 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 became
effective for the Company beginning January 1, 2008.  Upon adoption of
SFAS 159, there was no material impact on the Company’s condensed consolidated
financial statements.
 
 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, SFAS 157 does not require any new fair value measurements. SFAS 157
became effective for the Company beginning January 1, 2008. Upon adoption of
SFAS 157, there was no material impact on the Company’s condensed consolidated
financial statements.
  In
February 2008, the FASB issued FASB Staff Position (“FSP”) No. 157-2 (“FSP
157-2”), which delays the effective date of SFAS No. 157 for one year for all
nonfinancial assets and nonfinancial liabilities, except those that are
recognized or disclosed at fair value in the financial statements on a recurring
basis. The Company elected a partial deferral of SFAS No. 157 under the
provisions of FSP 157-2 related to the measurement of fair value used when
evaluating goodwill, other intangible assets and other long-lived assets for
impairment. See Note 3 for further information and related disclosures regarding
the Company’s fair value measurements.
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  Interactive Intelligence, Inc.
 Notes
to Condensed Consolidated Financial Statements
(continued)
 3.
                  FAIR
      VALUE MEASUREMENTS
 
 SFAS 157
defines fair value as the exchange price that would be received for an asset or
paid to transfer a liability (an exit price) in the principal or most
advantageous market for the asset or liability in an orderly transaction between
market participants on the measurement date. SFAS 157 also establishes a fair
value hierarchy which requires an entity to maximize the use of observable
inputs and minimize the use of unobservable inputs when measuring fair value.
The standard describes the following three levels of inputs that may be used to
measure fair value:
  ●
                      Level 1 - Unadjusted
      quoted prices in active markets that are accessible at the measurement
      date for identical, unrestricted assets or
  liabilities.
  ●
                      Level 2 - Observable
      inputs other than Level 1 prices such as quoted prices for similar assets
      or liabilities; quoted prices in markets that are not active; or other
      inputs that are observable or can be corroborated by observable market
      data for substantially the full term of the assets or
      liabilities.
  ●
                      Level 3 - Unobservable
      inputs that are supported by little or no market activity and that are
      significant to the fair value of the assets or
  liabilities.
 The
Company’s assets that are measured at fair value on a recurring basis are
generally classified within Level 1 or Level 2 of the fair value
hierarchy.  The types of instruments valued based on quoted market
prices in active markets include most money market securities and equity
investments.  Such instruments are generally classified within Level 1
of the fair value hierarchy.  The Company invests in money market
funds that are traded daily and does not adjust the quoted price for such
instruments.  The types of instruments valued based on quoted prices
in less active markets, broker or dealer quotations, or alternative pricing
sources with reasonable levels of price transparency include the Company’s
corporate notes, commercial paper and asset-backed securities.  Such
instruments are generally classified within Level 2 of the fair value
hierarchy.  The Company uses consensus pricing, which is based on
multiple pricing sources, to value its fixed income
investments.
 The
following table sets forth a summary of the Company’s financial assets,
classified as cash and cash equivalents and short-term investments on its
condensed consolidated balance sheet, measured at fair value on a recurring
basis as of March 31, 2008 (in thousands):
 Fair
      Value Measurements at
                    Reporting
      Date UsingDescription
                  
                  Total
                  
                  Quoted
      Prices in
                      Active
      Markets for
                      Identical
      Assets
                      (Level
      1)
                  
                  Significant
                      Other
      Observable
                      Inputs
                      (Level
      2)
                  
                  Significant
                      Unobservable
                      Inputs
                      (Level
      3)Cash
      & cash equivalents:Money
      Market Funds
                  
                  $
                  6,049
                  
                  $
                  6,049
                  
                  $
                  --
                  
                  $
                  --Short-term
      investments:Corporate
      Notes
                  
                  $
                  4,846
                  
                  $
                  --
                  
                  $
                  4,846
                  
                  $
                  --Commercial
      Paper
                  
                  
                  4,600
                  
                  
                  --
                  
                  
                  4,600
                  
                  
                  --Asset-Backed
      Securities
                  
                  
                  3,019
                  
                  
                  --
                  
                  
                  3,019
                  
                  
                  --Total
                  
                  $
                  12,465
                  
                  $
                  6,049
                  
                  $
                  12,465
                  
                  $
                  --
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  Interactive Intelligence, Inc.
 Notes
to Condensed Consolidated Financial Statements (continued)
 4.
                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
anti-dilutive. Potential common shares are composed of shares of common stock
issuable upon the exercise of stock options. The following table sets forth the
calculation of basic and diluted net income per share (in thousands, except per
share amounts):
 Three
      Months Ended
                    March
      31,2008
                
                
                2007Net
      income, as reported (A)
                
                $
                1,117
                
                
                $
                1,753Weighted
      average shares of common stock outstanding (B)
                
                
                17,940
                
                
                
                17,247Dilutive
      effect of employee stock options
                
                
                1,276
                
                
                
                1,989Common
      stock and common stock equivalents (C)
                
                
                19,216
                
                
                
                19,236Net
      income per share:Basic
      (A/B)
                
                $
                0.06
                
                
                $
                0.10Diluted
      (A/C)
                
                
                0.06
                
                
                
                0.09
 
 The
Company’s calculation of diluted net income per share for the three months ended
March 31, 2008 and 2007 excludes stock options to purchase approximately 1.1
million and 412,000 shares of the Company’s common stock, respectively, as their
effect would be anti-dilutive.
 
 5.
                STOCK-BASED
      COMPENSATION
 
 Stock
Option Plans
 
 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 by the Company’s
shareholders in May 2006, the Company may no longer make any grants under
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 are added to shares available under the 2006
Plan. A maximum of 4,950,933 shares are available for delivery under the 2006
Plan, which consists of (i) 1,250,000 shares, plus (ii) 320,000 shares available
for issuance under the 1999 Plans, but not underlying any outstanding stock
options or other awards under the 1999 Plans, plus (iii) up to 3,380,933 shares
subject to outstanding stock options or other awards under the 1999 Plans that
expire, are forfeited or otherwise terminate unexercised on or after May 18,
2006. The number of shares available under the 2006 Plan is subject to
adjustment for certain changes in the Company’s capital structure. The exercise
price of 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
business day immediately preceding the date of grant.
 
 The
Company currently issues two types of stock options: (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-based
vesting.  The fair value of these 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.
 
 Performance-based
stock options are typically granted to executive officers during the first
quarter of the year with the grants subject to cancellation if specified
performance targets, as approved by the Company’s Compensation Committee,
are not achieved.  If the applicable performance targets have been
achieved, the options will vest in four equal annual installments beginning one
year after the performance-related year has ended.
 
 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 specified performance targets
must be met.  Although the valuation assumptions used for executive
officer grants are similar to grants made to non-executive and director grants,
the assumptions for executive officer grants are used to measure each vesting
tranche of the awards.
 
 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 10% 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.
  - 9
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  Interactive Intelligence, Inc.
 Notes
to Condensed Consolidated Financial Statements (continued)
 Stock-Based
Compensation Expense Information
  The
following table summarizes the allocation of stock-based compensation expense
related to employee and director stock options under SFAS No. 123 (revised
2004), Share-Based
Payment, and the guidance of SAB 107, as amended by SAB
110,  for the three months ended March 31, 2008 and 2007 (in
thousands):
  Three
      Months Ended
                    March
      31,2008
                
                
                2007Stock-based
      compensation expense by category:Cost
      of services
                
                $
                72
                
                
                $
                46Sales
      and marketing
                
                
                362
                
                
                
                300Research
      and development
                
                
                208
                
                
                
                100General
      and administrative
                
                
                290
                
                
                
                222Total
      stock-based compensation expense
                
                $
                932
                
                
                $
                668
 
 6.
                CONCENTRATION
      OF CREDIT RISK
 
 One of
the Company’s partners represented a 10% concentration of the Company’s accounts
receivables as of March 31, 2008. No customer or partner accounted for 10% or
more of the Company’s accounts receivable as of December 31, 2007. In addition,
no customer or partner accounted for 10% or more of the Company’s revenues
for the three months ended March 31, 2008 and 2007.
 
 7.
                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 ($3.7 million
for VAT and $371,000 for corporation taxes). Because the judgment from the
French court was against Interactive Intelligence France S.A.R.L. (“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
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
March 31, 2008, the assessment related to VAT was approximately $6.7 million and
the assessment related to corporation taxes was approximately
$807,000.  As of March 31, 2008, the Company has recorded an
accrual for an amount it deems probable of payment for the corporation tax
assessment. No accrual has been made by the Company with respect to the VAT
assessment.
 
 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.
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  Interactive Intelligence, Inc.
 Notes
to Condensed Consolidated Financial Statements (continued)
 Lease
Commitment
 
 The
Company leases its world headquarters building under an operating lease
agreement (“world headquarters lease”), which expires on March 31, 2018 (the
“lease expiration date”). The 120,000 square foot building is located in
Indianapolis, Indiana. In addition, on June 19, 2007 and March 14, 2008, the
Company entered into the third and fourth amendments, respectively, of its world
headquarters lease under which the current leased space is to be expanded
in three installments through March 2009 totaling approximately 80,000 square
feet in an office building that is adjacent to the Company’s world headquarters.
Rent payments for the expanded space commenced in March 2008. In
consideration for entering into the amendments, the landlord paid the Company a
total discretionary allowance of $478,000. The allowance, which the Company
intends to use for certain costs associated with its world headquarters building
and/or the additional space, as defined in the amendment, will be recognized as
a reduction of rent expense over the term of the world headquarters
lease.
  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.
 
 8.
                INCOME
      TAXES
 
 The
following table sets forth the items accounting for the difference between
expected income tax expense compared to actual income tax expense recorded in
the Company’s condensed consolidated financial statements (in
thousands):
 Three
      Months EndedMarch
      31,2008
                  
                  
                  2007Expected
      income tax expense at 35% tax rate
                  $
                  (715
                  )
                  
                  $
                  (648
                  )State
      taxes, net of federal benefit
                  
                  (117
                  )
                  
                  
                  (93
                  )Non-deductible
      stock-based compensation expense
                  
                  (190
                  )
                  
                  
                  (162
                  )Foreign
      income tax expense
                  
                  104
                  
                  
                  
                  77Change
      in deferred tax asset valuation allowance
                  
                  --
                  
                  
                  
                  729Other
                  
                  7
                  
                  
                  
                  --Income
      tax expense
                  $
                  (925
                  )
                  
                  $
                  (97
                  )
 
 Upon
adoption of FASB Interpretation No. 48, Accounting for Uncertainty in Income
Taxes an interpretation of FASB Statement No. 109, the Company has
identified an uncertain tax position related to certain tax credits that the
Company currently believes meets the “more likely than not” recognition
threshold to be sustained upon examination. Prior to the fourth quarter of 2007,
this uncertain tax position had not been recognized because the Company had a
valuation allowance established.  The balance of the unrecognized tax
benefit was approximately $328,000 at December 31, 2007 and, if recognized,
would impact the effective tax rate. As of March 31, 2008, the unrecognized tax
benefit has not changed.
 The
Company and its subsidiaries file federal income tax returns and income tax
returns in 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 carryforwards at December 31, 2007
will remain subject to examination until the respective tax year is
closed.
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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, 2007. 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, 2007.
  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, Indiana 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
website located at http://investors.inin.com
under “SEC Filings”.
 
 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
installed by customers in a wide range of industries including, but not limited
to, financial institutions, higher education, healthcare, retail, technology,
government, business services and increasingly for the remote and mobile
workforce.   We also offer a pre-integrated all-software Internet
Protocol Private Branch Exchange (“IP PBX”) system, a phone and communications
solution for mid- to large-sized enterprises that rely on the Microsoft
Corporation (“Microsoft”) platform. We offer innovative software products and
services for multi-channel contact management, business communications,
messaging, and VoIP solutions supported on the Session Initiation Protocol
(“SIP”) global communications standard. Many of our solutions can be deployed at
the customer’s site or can be provided in a Software as a Service
model.
 
 Our
application-based solutions are integrated on a platform developed to increase
security, broaden integration to business systems and end-user devices, enhance
mobility for today’s workforce, scale to thousands of users, and more wholly
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
multi-channel communications media, enhance workforce effectiveness and
productivity, and more readily adapt to constantly-changing market and customer
requirements. Moreover, organizations in every industry are able to reduce the
cost and complexity of traditional “multi-point” legacy communications hardware
systems that are seldom fully integrated.
  For
further information on our business and the products and services we offer,
refer to the Item 1 “Business” section of our Annual Report on Form 10-K
for the year ended December 31, 2007.
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 Financial
Highlights
 
 For the
three months ended March 31, 2008, revenues grew 1% over the previous three
month period and 21% over the three months ended March 31, 2007. The increase
over the three months ended March 31, 2007 was primarily due to a 39% increase
in the dollar value of orders.
 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 other contractual conditions can
affect whether we 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, 2007, 2006 and 2005 and the
percentage change over the previous period (including the impact of
reclassifications and adjustments as discussed in Note 1 of Notes to Condensed
Consolidated Financial Statements).
 
 Period
              
              Revenues
              
              
              Growth %Three Months
      Ended:March
      31, 2008
              
              $
              29.5
              
              
              1
              %December
      31, 2007
              
              
              29.3
              
              
              --
              %September
      30, 2007
              
              
              29.2
              
              
              8
              %June
      30, 2007
              
              
              27.1
              
              
              12
              %March
      31, 2007
              
              
              24.3
              
              
              2
              %Year Ended December
      31:2007
              
              $
              109.9
              
              
              32
              %2006
              
              
              83.0
              
              
              32
              %2005
              
              
              62.9
              
              
              14
              %
 
 During
the first quarter of 2008, product revenues increased, compared to the same
period in 2007, as a result of increased demand for our software and appliances,
third party products we license and third party hardware we sell. We experienced
a 19% and 25% increase in revenue growth in North America and Europe, the Middle
East and Africa, respectively, during the first quarter of 2008 in part due to
an increase in demand for our contact center solutions, compared to the same
quarter in 2007. We also attribute 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 functionality 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.
 
 During
the first quarter of 2008, compared to the same period in 2007, services
revenues primarily increased due to additional support fees and annually
renewable license fees, which were recognized for our growing installed customer
base. Professional services slightly increased due to the increased delivery of
professional services that assisted in implementation of our solutions at our
customers’ locations.
 
 Our costs
of product increased due to our media servers and gateways appliances that 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.
 Our costs
of services and operating expenses, which include sales and marketing, research
and development and general and administrative expenses, increased for the three
months ended March 31, 2008, compared to the same quarter in 2007, primarily due
to a $2.6 million, or 17%, increase in company-wide staffing at March 31, 2008,
compared to March 31, 2007. Included in the compensation expense increase during
the first quarter of 2008 was $264,000 of additional stock-based compensation
expense related to Financial Accounting Standards Board (“FASB”) Statement of
Financial Accounting Standards (“SFAS”) No. 123 (revised 2004), Share-Based Payment (“SFAS
123R”), compared to the same period in 2007. We expect stock-based compensation
expense related to SFAS 123R to be approximately $2.7 million for the remainder
of 2008. In addition, our general corporate allocable costs including rent,
insurance and depreciation increased primarily due to additional offices we
opened after the first quarter of 2007.  In March 2008, we expanded
into one floor of a new building adjacent to our world headquarters and will be
expanding into another floor later in the year. We also opened or expanded
offices domestically and internationally.
 
 During
the first quarter of 2008, we recorded income tax expense of $925,000, compared
to $97,000 in the same quarter during 2007. During the fourth quarter of 2007,
we recorded a tax benefit of $8.1 million associated with the reduction in the
valuation allowance for the deferred tax assets. There was no valuation
allowance at December 31, 2007.  As the deferred tax assets recorded
in our condensed consolidated financial statements are utilized, we record
deferred income tax expense. Of the $925,000 total income tax expense recorded,
only $104,000 is expected to result in cash payments, and the remainder was the
impact of utilizing the deferred tax assets.
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 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 months ended March 31, 2008 and
2007 are not necessarily indicative of the results that may be expected for the
full year or for any future period.
 Three
      Months Ended
                  March
      31,2008
              
              
              2007Revenues:Product
              
              
              50
              %
              
              
              51
              %Services
              
              
              50
              
              
              
              49Total
      revenues
              
              
              100
              
              
              
              100Cost
      of revenues:Product
              
              
              11
              
              
              
              10Services
              
              
              20
              
              
              
              20Total
      cost of revenues
              
              
              31
              
              
              
              30Gross
      profit
              
              
              69
              
              
              
              70Operating
      expenses:Sales
      and marketing
              
              
              34
              
              
              
              35Research
      and development
              
              
              17
              
              
              
              16General
      and administrative
              
              
              13
              
              
              
              13Total
      operating expenses
              
              
              64
              
              
              
              64Operating
      income
              
              
              5
              
              
              
              6Other
      income (expense):Interest
      income, net
              
              
              2
              
              
              
              2Other
      income (expense), net
              
              
              --
              
              
              
              --Total
      other income
              
              
              2
              
              
              
              2Income
      before income taxes
              
              
              7
              
              
              
              8Income
      tax expense
              
              
              (3
              )
              
              
              --Net
      income
              
              
              4
              %
              
              
              7
              %
  - 14
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  Comparison
of Three Months Ended March 31, 2008 and 2007
  Revenues
 Three
      Months EndedProduct
      Revenues
              
              March
      31,2008
              
              
              2007($ in
      thousands)Product
      revenues
              
              $
              14,845
              
              
              $
              12,356Change
      from prior year period
              
              
              20
              %
              
              
              39
              %Percentage
      of total revenues
              
              
              50
              %
              
              
              51
              %
 
 Product
revenues, which include software and hardware revenues, increased $2.5 million
during the first quarter of 2008 compared to the same period in 2007. During the
three months ended March 31, 2008, orders received increased 39% and we received
15 orders between $250,000 and $1.0 million, compared to seven such orders
received during the same quarter in 2007. Our existing installed customer base
accounted for 75% of our orders received during the first quarter of 2008 while
a majority of the orders entered into between $250,000 and $1.0 million were
generated through new customers. We also received an increase in hardware orders
of $882,000, or 96%, during the first quarter of 2008, compared to the same
quarter in 2007, which was primarily due to a higher demand for our media server
and interaction gateway appliances, which have added to the scalability and
functionality of our solutions.
 
 Product
revenues can fluctuate from quarter to quarter depending on the mix of orders
between perpetual licenses and annually renewable licenses.  If other
revenue recognition criteria are satisfied, we recognize license revenue upfront
for perpetual licenses, and we recognize revenue for annually renewable licenses
ratably over the term.  The impact of the mix of contracts on our
product revenues occurs only in the initial year of an order; subsequent renewal
fees received for the annually renewable licenses and the renewal support fees
for perpetual contracts are all allocated entirely to services
revenues.
 
 Three
      Months EndedServices
      Revenues
              
              March
      31,2008
              
              
              2007($ in
      thousands)Services
      revenues
              
              $
              14,638
              
              
              $
              11,932Change
      from prior year period
              
              
              23
              %
              
              
              32
              %Percentage
      of total revenues
              
              
              50
              %
              
              
              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, educational and other miscellaneous
revenues.
 
 The
increase during the first quarter of 2008 compared to the same period in 2007
was primarily due to our growing installed base of customers, both in number and
size, and the related payments of annual license renewal fees and support fees
for perpetual licenses. License renewal and support revenues increased by $2.3
million, or 26%, during the three months ended March 31, 2008, compared to the
same period in 2007. As we sign contracts and install our solutions with new
customers and partners, we expect that our services revenues will continue to
increase as customers and partners renew licenses and pay for support on our
software applications.  The actual percentage fee charged for renewal of
annually renewable licenses and perpetual support agreements as compared to the
initial annually renewable license fee and perpetual license, respectively, is
comparable on a relative percentage basis, and therefore, the mix of these types
of contracts in the future is not expected to impact our future services
revenues.
 
 During
the first quarter of 2008, our professional services revenues increased
$127,000, or 7%, and our educational and other services increased $255,000, or
22%, primarily due to the increased delivery of professional
services, compared to the same period in 2007. These professional services
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.
  Three
      Months EndedCost of Revenues
              
              March
      31,2008
              
              
              2007Cost
      of revenues:
              
              ($ in
      thousands)Product
              
              $
              3,130
              
              
              $
              2,441Services
              
              
              5,897
              
              
              
              4,797Total
      cost of revenues
              
              $
              9,027
              
              
              $
              7,238Change
      from prior year period
              
              
              25
              %
              
              
              65
              %Product
      costs as a % of product revenues
              
              
              21
              %
              
              
              20
              %Services
      costs as a % of services revenues
              
              
              40
              %
              
              
              40
              %
  Costs of product consist of hardware
costs, principally for media server and interaction gateway 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.
 
 The
majority of the increase in costs of product resulted from a $527,000 increase
in hardware costs from $1.2 million to $1.7 million. The additional increase was
due to slightly higher shipping costs and royalties paid to third
parties.
  - 15
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 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 primarily due to
a $962,000 increase in compensation expense, as a result of a 25% staffing
increase in our services personnel at March 31, 2008 compared to March 31, 2007.
In the second quarter of 2007, we acquired the professional services division of
Alliance Systems Ltd. (“Alliance”), which added 13 engineers to our professional
services group and contributed significantly to our increased compensation
expenses in the first quarter of 2008 compared to the same period in
2007.  As a result of the increased professional services staff during
the first quarter of 2008, travel related expenses also increased $125,000,
compared to the same period in 2007. In addition, because of our Alliance
acquisition, our expenses related to outsourced services decreased by $393,000
during the first quarter of 2008, compared to the same period in
2007.
 
 We
anticipate costs of services will continue to increase based on additional
personnel costs and delivery of professional services to our existing
installed customer base and potential new customers.
  Three
      Months EndedGross Profit
              
              March
      31,2008
              
              
              2007($ in
      thousands)Gross
      profit
              
              $
              20,456
              
              
              $
              17,050Change
      from prior year period
              
              
              20
              %
              
              
              26
              %Percentage
      of total revenues
              
              
              69
              %
              
              
              70
              %
 
 Gross
profit as a percentage of total revenues decreased slightly during the first
quarter of 2008, compared to the same period in 2007, primarily due to
additional costs of product 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 such as media servers,
interaction gateways and telephone handsets, our total gross margin percentage
may decrease compared to historical margins. Gross margins in any particular
quarter are dependent upon revenues recognized versus costs of product and costs
of services incurred and are expected to vary.
 
 Operating
Expenses
 Three
      Months EndedSales
      and Marketing
              
              March
      31,2008
              
              
              2007($ in
      thousands)Sales
      and marketing expenses
              
              $
              10,178
              
              
              $
              8,654Change
      from prior year period
              
              
              18
              %
              
              
              26
              %Percentage
      of total revenues
              
              
              34
              %
              
              
              35
              %Percentage
      of net product revenues
              
              
              87
              %
              
              
              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 $471,000
during the three months ended March 31, 2008, which was due in part to an 8%
staffing increase in our sales and marketing personnel at March 31, 2008,
compared to March 31, 2007. We increased our corporate marketing efforts during
the first quarter of 2008 compared to the same period in 2007, which included
increased advertising and brand promotions, seminars, web seminars and
tradeshows resulting in an increased cost of
$436,000.  Outsourced services increased $213,000 during the first
quarter of 2008, compared to the same period in 2007, primarily due to lead
generation activities and redevelopment of our corporate website. We also
incurred an increase of $118,000 during the first three months in 2008, compared
to the same period in 2007, primarily due to more referral fees paid to our
customers and partners. General corporate expenses such as rent, communication
and depreciation expenses increased a combined $198,000 during the first quarter
of 2008, compared to the same period in 2007 and were mainly due to leasehold
improvements and related purchases in several new sales and marketing
offices.
 
 We expect
sales and marketing costs to continue to increase primarily due to additional
personnel costs and expansion of our marketing and channels efforts to increase
our brand awareness and distribution.
 Three
      Months EndedResearch
      and Development
              
              March
      31,2008
              
              
              2007($ in
      thousands)Research
      and development expenses
              
              $
              4,965
              
              
              $
              3,897Change
      from prior year period
              
              
              27
              %
              
              
              25
              %Percentage
      of total revenues
              
              
              17
              %
              
              
              16
              %
 
 Research
and development expenses are comprised primarily of compensation and
depreciation expenses. Research and development expenses increased during the
three months ended March 31, 2008, as compared to the same period in 2007,
primarily due to an increase in compensation expense of $783,000, resulting from
an 18% staffing increase in our research and development personnel at March 31,
2008 compared to March 31, 2007. General corporate expenses such as rent,
communication and depreciation expenses increased a combined $140,000 during the
first quarter of 2008, compared to the same period in 2007 and were mainly due
to leasehold improvements and related purchases in the new building adjacent to
our world headquarters.
 
 We
continue to believe that investment in research and development is critical to
our future growth and competitive position in the marketplace and is directly
related to timely development of new and enhanced solutions that are central to
our business. As a result, we expect research and development expenses will
increase in future periods. In the short term, we expect research and
development expenses to remain a relatively constant percentage of
revenues.
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 Three
      Months EndedGeneral
      and Administrative
              
              March
      31,2008
              
              
              2007($ in
      thousands)General
      and administrative expenses
              
              $
              3,827
              
              
              $
              3,065Change
      from prior year period
              
              
              25
              %
              
              
              21
              %Percentage
      of total revenues
              
              
              13
              %
              
              
              13
              %
 
 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 months ended March 31, 2008, as compared to
the same period in 2007, primarily due to an increase in compensation expense of
$336,000, as a result of a 17% staffing increase in our general and
administrative personnel at March 31, 2008 compared to March 31, 2007.
Professional services expenses increased $230,000 during the first quarter of
2008, compared to the same period in 2007, principally due to incremental
accounting, legal and tax fees.
 
 As we
continue to expand, we expect general and administrative expenses will continue
to increase primarily due to additional personnel costs, and increases in
supplies and depreciation expense of leasehold improvements and other
assets.
 
 Other
Income (Expense)
 Three
      Months EndedInterest
      Income, Net
              
              March
      31,2008
              
              
              2007($ in
      thousands)Cash,
      cash equivalents and short-terminvestments
      (average)
              
              $
              47,882
              
              
              $
              29,300Interest
      income
              
              
              459
              
              
              
              472Return
      on investment (annualized)
              
              
              3.8
              %
              
              
              6.4
              %
 
 Interest
earned on investments during the first quarter of 2008, compared to the same
period in 2007, decreased slightly due to lower interest rates on
investments.  We continue to monitor the allocation of funds in which
we have invested to maximize our return on investment.  We do not have
any investments in subprime assets.
 
 Three
      Months EndedOther Income (Expense),
      Net
              
              March
      31,2008
              
              
              2007($ in
      thousands)Other
      income (expense)
              
              $
              97
              
              
              $
              (56
              )
 
 Other
income (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 income for the first quarter of 2008
consisted of $209,000 in gains related to foreign currency transactions, offset
by $112,000 in foreign tax withholdings.  The expense during the first
quarter of 2007 consisted primarily of foreign tax withholdings.
 
 Three
      Months EndedIncome
      tax expense
              
              March
      31,2008
              
              
              2007($ in
      thousands)Income
      tax expense
              
              $
              (925
              )
              
              $
              (97
              )
 
 In the
fourth quarter of 2007, we recorded an $8.1 million income tax benefit to reduce
the valuation allowance of the deferred tax assets at December 31,
2007.  As a result, we began recording income tax expense in the first
quarter of 2008. We incurred $925,000 of income tax expense during the three
months ended March 31, 2008; however, only $104,000 of the income tax expense
recorded is expected to result in cash payments and the remaining $821,000 was
associated with the utilization of the deferred tax
assets.
 
 We had
over $45.5 million of tax net operating loss carryforwards and $1.6 million in
tax credit carryforwards at December 31, 2007. Included in the net operating
loss carryforwards was $23.1 million of operating losses that were generated as
a result of excess tax benefits for stock options.  In accordance with
SFAS 123R, these stock option deductions have not been recognized for financial
reporting purposes because they have not yet reduced taxes
payable.  The tax benefit of these deductions will be primarily
recorded as a credit to additional paid-in capital. The effective income tax
rate was 45% for the three months ended March 31, 2008. However, due to the tax
net operating loss carryforwards, the tax credit carryforwards and stock option
related compensation deductions, we do not expect to have a significant cash
outlay to pay income taxes in 2008. Most of the income tax expense during the
first quarter of 2008 is a non-cash reduction of the deferred tax
assets.
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  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 use cash primarily for paying
our employees (including salaries, commissions and benefits), leasing office
space, paying travel expenses and marketing activities, paying vendors for
hardware, other services and supplies and purchasing property and equipment. We
continue to be debt free.
 
 We
determine liquidity by combining cash and cash equivalents and short-term
investments as shown in the table below. Based on our recent performance
and current expectations, we believe that our current liquidity position, when
combined with our anticipated cash flows from operations, will be sufficient to
satisfy our working capital needs, capital expenditures, investment
requirements, contractual obligations, commitments and other liquidity
requirements associated with our operations 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. In
doing so, we may not be able to receive favorable terms in raising this
capital.
  On
October 31, 2007, our shelf registration statement on Form S-3, as amended, was
declared effective by the SEC.  This registration statement allows us
to offer and sell up to 3,000,000 shares of our common stock, and allows Dr.
Donald E. Brown, our Chairman of the Board, President and CEO, to sell up to
1,000,000 shares of our common stock that he owns, from time to time in one or
more transactions.  The offer and sale of any shares of our common
stock under the shelf registration statement 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.
  Our
liquidity position at March 31, 2008 and December 31, 2007 was as
follows:
 March
      31,
              
              
              December
      31,2008
              
              
              2007($ in thousands)Cash
      and cash equivalents
              $
              36,972
              
              
              $
              29,270Short-term
      investments
              
              12,465
              
              
              
              17,057Liquidity,
      net
              $
              49,437
              
              
              $
              46,327
  The
amount that we report as cash and cash equivalents or as short-term investments
fluctuates depending on investing decisions in each period. Purchases of
short-term investments and property and equipment are reported as a use of cash
and the related receipt of proceeds upon maturity of investment is reported as a
source of cash.
 
 During
the three months ended March 31, 2008 and 2007, our operating activities
resulted in net cash provided of $5.3 million and $4.9 million,
respectively.
 Net cash
provided by investing activities was $2.0 million and $3.4 million during the
three months ended March 31, 2008 and 2007, respectively. The decrease in cash
provided resulted primarily from property and equipment with a cost of $2.6
million purchased during the three months ended March 31, 2008, compared to $1.3
million purchased in the same period in 2007. In March 2008, we expanded into
one floor of a new building adjacent to our world headquarters and will be
expanding into another floor later in the year. These purchases related mainly
to leasehold improvements for our new building. We also opened or expanded
offices domestically and internationally. As staffing increases, our property
and equipment becomes obsolete and our operations continue to increase, we
anticipate that our purchases of property and equipment will continue to
increase in future periods.
 
 Net cash
provided by financing activities was $344,000 and $724,000 for the three months
ended March 31, 2008 and 2007, respectively. The decrease in cash provided was
mainly due to lower proceeds from stock options that were exercised during the
three months ended March 31, 2008, compared to the same period in
2007.
  As of
March 31, 2008, 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, 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, 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 March 31, 2008.
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  Critical
Accounting Policies and Estimates
  The
preparation of our condensed consolidated financial statements requires us to
make estimates and judgments that affect the reported amount of assets,
liabilities, revenue and expenses.  Actual results may differ from
those estimates and judgments under different assumptions or
conditions.  We have discussed the critical accounting policies that
we believe affect our more significant estimates and judgments used in the
preparation of our consolidated financial statements in the “Management’s
Discussion and Analysis of Financial Condition and Results of the
Operations—Critical Accounting Policies and Estimates” section of our Annual
Report on Form 10-K for the year ended December 31, 2007 and in Note 2 of Notes
to Consolidated Financial Statements included in our Annual Report on Form 10-K
for the year ended December 31, 2007.  For a further summary of
certain accounting policies, see Note 2 of Notes to Condensed Consolidated
Financial Statements included in Part I, Item 1 of this Quarterly Report on Form
10-Q.
  Item 3. Quantitative
and Qualitative Disclosures about Market Risk.
 We
develop software application products in the United States and license our
products worldwide. As a result, our financial results could be affected by
various factors, including changes in foreign currency exchange rates or weak
economic conditions in certain markets. We transact business in certain foreign
currencies including the British pound and the Euro. However, as a majority of
the orders we receive are denominated in United States dollars, a strengthening
of the dollar could make our products more expensive and less competitive in
foreign markets. We have not historically used foreign currency options or
forward contracts to hedge our currency exposures because of variability in the
timing of cash flows associated with our larger contracts.  We did not
have any such hedge instruments in place at March 31, 2008. Rather, we attempt
to mitigate our foreign currency risk by generally transacting business and
paying salaries in the functional currency of each of the major countries in
which we do business, thus creating natural hedges. Additionally, as our
business matures in foreign markets, we may offer our products and services in
certain other local currencies. As a result, foreign currency fluctuations would
have a greater impact on our company and may have an adverse effect on our
results of operations. Historically, our gains or losses on foreign currency
exchange translations have been immaterial to our consolidated financial
statements.
 
 We invest
cash balances in excess of operating requirements in short-term securities that
generally have maturities of one year or less. The carrying value of these
securities approximates market value, and there is no long-term interest rate
risk associated with these investments.
 
  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 March
31, 2008 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 March 31, 2008 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 7 of Notes to Condensed Consolidated Financial
Statements included in Part I, Item 1 of this Quarterly Report on Form 10-Q is
incorporated herein by reference.
   Item 1A. Risk
Factors.
 In
addition to the information set forth in this Quarterly Report on Form 10-Q 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, 2007. 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 March 31, 2008, there were no material changes from risk factors
previously disclosed in our Annual Report on Form 10-K for the year ended
December 31, 2007.
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  Item 6. Exhibits.
 (a)
              Exhibits
 
 Incorporated
      by ReferenceExhibit
      Number
              
              Exhibit
      Description
              
              Form
              
              Exhibit
              
              Filing
      Date
              
              Filed
                Herewith3.1
              
              Restated
      Articles of Incorporation of the Company, as currently in
      effect
              S-1
                (Registration
      No.
                333-79509)
              
              3.1
              
              5/28/19993.2
              
              Amended
      By-Laws of the Company, as currently in effect
              
              8-K
              
              3.2
              
              8/21/200710.16
              
              Fourth
      Lease Amendment, dated March 14, 2008, between the Company and Duke Realty
      Limited Partnership (formerly Duke-Weeks Realty Limited
      Partnership)
              
              
              
              
              
              
              X31.1
              
              Certification
      of the Chief Executive Officer pursuant to Rule 13a-14(a)/15d-14(a) of the
      Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the
      Sarbanes-Oxley Act of 2002
              
              
              
              
              
              
              X31.2
              
              Certification
      of the Chief Financial Officer pursuant to Rule 13a-14(a)/15d-14(a) of the
      Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the
      Sarbanes-Oxley Act of 2002
              
              
              
              
              
              
              X32.1
              
              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
      2002
              
              
              
              
              
              
              X32.2
              
              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
              
              
              
              
              
              
              X
 
 
 
 
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 SIGNATURES
  Pursuant
to the requirements of the Securities Exchange Act of 1934, the registrant has
duly caused this report to be signed on its behalf by the undersigned hereunto
duly authorized.
  Interactive
      Intelligence, Inc.
                (Registrant)Date:   May
      12, 2008
              
              
              
              By:
              
              /s/  Stephen
      R. HeadStephen
      R. Head
                Chief
      Financial Officer,
                Vice
      President of Finance and Administration,
                Secretary
      and Treasurer
                (Principal
      Financial Officer and Principal Accounting
  Officer)


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