** **

**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

 

**Washington, D.C. 20549**

 

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**FORM 10-Q**

 

|                                                                                                                                                                                                                                       | **(Mark One)**                                                                                                                                                                        |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                                                                                                                                                                                                                                       |                                                                                                                                                                                  |
|                                                                                                                                                                                                                                       | **ý****         QUARTERLY REPORT  PURSUANT TO SECTION 13      OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|                                                                                                                                                                                                                                       |                                                                                                                                                                                  |
| **For the quarterly period ended June  30, 2003**                                                                                                                                                                                          |
|                                                                                                                                                                                                                                       |
| **Or**                                                                                                                                                                                                                                     |
|                                                                                                                                                                                                                                       |
|                                                                                                                                                                                                                                       | **o****         TRANSITION REPORT  PURSUANT TO SECTION 13      OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**     |
|                                                                                                                                                                                                                                       |
| **For the transition period from                    to                  ** |
|                                                                                                                                                                                                                                       |
| **Commission  File Number 000-27385**                                                                                                                                                                                                      |

 

| **INTERACTIVE  INTELLIGENCE, INC.**                             |
|-----------------------------------------------------------------|
| (Exact name of registrant as specified in its charter)          |
|                                                            |
| **Indiana**                                                     |   | **35-1933097** |
| (State or other jurisdiction of  incorporation or organization) |   | (IRS Employer Identification No.) |
|                                                            |
| **7601  Interactive Way  Indianapolis, Indiana 46278**          |
| (Address of principal executive offices)                        |
|                                                            |
| **(317) 872-3000**                                              |
| (Registrant’s telephone number)                            |

 

Indicate by checkmarkwhether the registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements for thepast 90 days.

 

Yes  ý   No  o

 

Indicate by check markwhether the registrant is an accelerated filer (as defined in Rule 12b-2 of theExchange Act).  Yes  o  No  ý

 

The number of shares ofcommon stock outstanding on July 31, 2003 was 15,636,983.

 

 

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TABLE OF CONTENTS

 
| PART I. FINANCIAL INFORMATION |
|-------------------------------|
|                          |   |
| Item 1.                       | Condensed Consolidated Balance Sheets as  of June 30, 2003 (unaudited) and December 31, 2002 |
|                          |   |
|                          | Condensed Consolidated  Statements of Operations for the three and six months ended June 30, 2003 and  2002 (unaudited) |
|                          |   |
|                          | Condensed Consolidated  Statements of Cash Flows for the six months ended June 30, 2003 and 2002  (unaudited) |
|                          |   |
|                          | Notes to Condensed Consolidated Financial  Statements |
|                          |   |
| Item 2.                       | Management’s Discussion and Analysis of  Financial Condition and Results of Operations |
|                          |   |
| Item 3.                       | Quantitative and Qualitative Disclosures About  Market Risk |
|                          |   |
| Item 4.                       | Controls and Procedures |
|                          |   |
| PART II. OTHER INFORMATION    |
|                          |   |
| Item 1.                       | Legal Proceedings |
|                          |   |
| Item 4.                       | Submission of Matters to a Vote of Security  Holders |
|                          |   |
| Item 5.                       | Other Information |
|                          |   |
| Item 6.                       | Exhibits and Reports on Form 8-K |
|                          |   |
| SIGNATURES                    |

 

2

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**PART I****.  FINANCIAL INFORMATION**

 

**Item 1****.  Condensed Consolidated Financial Statementsand Footnotes.**

 

**InteractiveIntelligence, Inc.**

 

**CondensedConsolidated Balance Sheets**

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

 
|                                                                                                                                                                |   | **June 30,  2003** |   | **December  31,  2002** |       |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|--------------------|--------|-------------------------|------------|
|                                                                                                                                                                |   | **(Unaudited)**    |   |                    | ** ** |
| **Assets**                                                                                                                                                          |   |               |   |                    |       |
| Current assets:                                                                                                                                                     |   |               |   |                    |       |
| Cash and cash equivalents                                                                                                                                           |   | $                  | 12,053 |                    | $          | 5,913 |   |
| Short-term investments                                                                                                                                              |   | 3,091              |   | 9,331                   |       |
| Accounts receivable, net of allowance for  doubtful accounts of $184 in 2003 and $671 in 2002                                                                       |   | 7,104              |   | 9,047                   |       |
| Prepaid expenses                                                                                                                                                    |   | 1,560              |   | 2,170                   |       |
| Other current assets                                                                                                                                                |   | 83                 |   | 73                      |       |
| Total current assets                                                                                                                                                |   | 23,891             |   | 26,534                  |       |
|                                                                                                                                                                |   |               |   |                    |       |
| Property and equipment, net                                                                                                                                         |   | 7,012              |   | 7,586                   |       |
|                                                                                                                                                                |   |               |   |                    |       |
| Other assets, net                                                                                                                                                   |   | 1,067              |   | 1,046                   |       |
| Total assets                                                                                                                                                        |   | $                  | 31,970 |                    | $          | 35,166 |   |
|                                                                                                                                                                |   |               |   |                    |       |
| **Liabilities and shareholders’  equity**                                                                                                                      |   |               |   |                    |       |
| Current liabilities:                                                                                                                                                |   |               |   |                    |       |
| Accounts payable and accrued liabilities                                                                                                                            |   | $                  | 4,625  |                    | $          | 3,203 |   |
| Accrued compensation and related expenses                                                                                                                           |   | 943                |   | 995                     |       |
| Deferred software revenues                                                                                                                                          |   | 9,288              |   | 12,102                  |       |
| Deferred services revenues                                                                                                                                          |   | 11,387             |   | 9,882                   |       |
| Total current liabilities                                                                                                                                           |   | 26,243             |   | 26,182                  |       |
|                                                                                                                                                                |   |               |   |                    |       |
| Shareholders’ equity:                                                                                                                                          |   |               |   |                    |       |
| Preferred stock,   no par value;  10,000,000  authorized; no shares issued and outstanding                                                                |   | —             |   | —                  |       |
| Common stock, $0.01 par value; 100,000,000  authorized; 15,601,647 issued and outstanding at June 30, 2003, 15,524,369  issued and outstanding at December 31, 2002 |   | 156                |   | 155                     |       |
| Additional paid-in capital                                                                                                                                          |   | 64,354             |   | 64,140                  |       |
| Accumulated other comprehensive income                                                                                                                              |   | 290                |   | 162                     |       |
| Accumulated deficit                                                                                                                                                 |   | (59,073            | )      | (55,473                 | )          |
| Total shareholders’ equity                                                                                                                                     |   | 5,727              |   | 8,984                   |       |
| Total liabilities and shareholders’ equity                                                                                                                     |   | $                  | 31,970 |                    | $          | 35,166 |   |

 

See accompanying notes to condensed consolidatedfinancial statements.

 

3

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**Interactive Intelligence,Inc.**

 

**CondensedConsolidated Statements of Operations (unaudited)**

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

 
|                                       |   | **Three months ended  June 30,** |       | **Six months ended  June 30,** |       |
|--------------------------------------------|--------|----------------------------------|------------|--------------------------------|------------|
|                                       |   | **2003**                         |       | **2002**                       |       | **2003** |   | **2002** |   |
|                                       |   |                             | ** ** |                           | ** ** |   | ** ** |   | ** ** |
| Revenues:                                  |   |                             |       |                           |       |   |   |   |   |
| Software                                   |   | $                                | 5,772      |                           | $          | 7,704 |   | $ | 14,393 |   | $ | 15,296 |   |
| Services                                   |   | 6,335                            |       | 4,416                          |       | 12,098 |   | 8,777 |   |
| Total revenues                             |   | 12,107                           |       | 12,120                         |       | 26,491 |   | 24,073 |   |
|                                       |   |                             |       |                           |       |   |   |   |   |
| Costs and expenses:                        |   |                             |       |                           |       |   |   |   |   |
| Costs of software                          |   | 325                              |       | 192                            |       | 617 |   | 464 |   |
| Costs of services                          |   | 3,254                            |       | 2,865                          |       | 6,440 |   | 5,888 |   |
| Sales and marketing                        |   | 4,910                            |       | 5,191                          |       | 10,117 |   | 10,740 |   |
| Research and development                   |   | 3,472                            |       | 3,712                          |       | 6,967 |   | 7,618 |   |
| General and administrative                 |   | 1,356                            |       | 1,381                          |       | 2,812 |   | 2,878 |   |
| Restructuring and other charges            |   | 2,690                            |       | 682                            |       | 3,138 |   | 682 |   |
| Total costs and expenses                   |   | 16,007                           |       | 14,023                         |       | 30,091 |   | 28,270 |   |
| Operating loss                             |   | (3,900                           | )          | (1,903                         | )          | (3,600 | ) | (4,197 | ) |
|                                       |   |                             |       |                           |       |   |   |   |   |
| Interest income, net                       |   | 43                               |       | 104                            |       | 96 |   | 233 |   |
| Loss before income taxes                   |   | (3,857                           | )          | (1,799                         | )          | (3,504 | ) | (3,964 | ) |
|                                       |   |                             |       |                           |       |   |   |   |   |
| Income taxes                               |   | 43                               |       | 60                             |       | 96 |   | 129 |   |
|                                       |   |                             |       |                           |       |   |   |   |   |
| Net loss                                   |   | $                                | (3,900     | )                              | $          | (1,859 | ) | $ | (3,600 | ) | $ | (4,093 | ) |
|                                       |   |                             | ** ** |                           | ** ** |   | ** ** |   | ** ** |
| Net loss per share:                        |   |                             | ** ** |                           | ** ** |   | ** ** |   | ** ** |
| Basic and diluted                          |   | $                                | (0.25      | )                              | $          | (0.12 | ) | $ | (0.23 | ) | $ | (0.27 | ) |
|                                       |   |                             |       |                           |       |   |   |   |   |
| Shares used to compute net loss per share: |   |                             |       |                           |       |   |   |   |   |
| Basic and diluted                          |   | 15,600                           |       | 15,398                         |       | 15,582 |   | 15,368 |   |

 

See accompanying notes to condensed consolidatedfinancial statements.

 

4

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**Interactive Intelligence,Inc.**

 

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

**(in thousands)**

 
|                                                                                    |   | **Six months ended  June 30,** |   |
|-----------------------------------------------------------------------------------------|--------|--------------------------------|--------|
|                                                                                    |   | **2003**                       |   | **2002** | ** ** |
| **Operating activities**                                                                |   |                           |   |   |   |
| Net loss                                                                                |   | $                              | (3,600 | ) | $ | (4,093 | ) |
| Adjustments to reconcile net loss to net cash  provided (used) by operating activities: |   |                           |   |   |   |
| Depreciation                                                                            |   | 2,447                          |   | 2,570 |   |
| Amortization of deferred stock-based compensation                                       |   | 46                             |   | 66 |   |
| Loss on disposal of fixed assets                                                        |   | 539                            |   | — |   |
| Restructuring and other charges                                                         |   | 2,900                          |   | 682 |   |
| Changes in operating assets and liabilities:                                            |   |                           |   |   |   |
| Accounts receivable                                                                     |   | 1,943                          |   | 182 |   |
| Prepaid expenses                                                                        |   | 610                            |   | 284 |   |
| Other current assets                                                                    |   | (10                            | )      | 104 |   |
| Accounts payable and other accrued liabilities                                          |   | (1,478                         | )      | (1,053 | ) |
| Accrued compensation and related expenses                                               |   | (52                            | )      | (125 | ) |
| Deferred software revenues                                                              |   | (2,814                         | )      | (2,303 | ) |
| Deferred services revenues                                                              |   | 1,505                          |   | 616 |   |
| Net cash provided (used) by operating activities                                        |   | 2,036                          |   | (3,070 | ) |
|                                                                                    |   |                           |   |   |   |
| **Investing activities**                                                                |   |                           |   |   |   |
| Purchases of property and equipment, net                                                |   | (2,412                         | )      | (1,710 | ) |
| Purchases of available-for-sale investments                                             |   | —                         |   | (9,121 | ) |
| Sales of available-for-sale investments                                                 |   | 6,368                          |   | 4,418 |   |
| Change in other assets                                                                  |   | (21                            | )      | (86 | ) |
| Net cash provided (used) by investing activities                                        |   | 3,935                          |   | (6,499 | ) |
|                                                                                    |   |                           |   |   |   |
| **Financing activities**                                                                |   |                           |   |   |   |
| Proceeds from issuances of common stock                                                 |   | 167                            |   | 248 |   |
| Proceeds from stock options exercised                                                   |   | 2                              |   | 109 |   |
| Net cash provided by financing activities                                               |   | 169                            |   | 357 |   |
| Net increase (decrease) in cash and cash  equivalents                                   |   | 6,140                          |   | (9,212 | ) |
|                                                                                    |   |                           |   |   |   |
| Cash and cash equivalents, beginning of period                                          |   | 5,913                          |   | 14,503 |   |
| Cash and cash equivalents, end of period                                                |   | $                              | 12,053 |   | $ | 5,291 |   |

 

See accompanying notes to condensed consolidatedfinancial statements.

 

5

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InteractiveIntelligence, Inc

Notesto Condensed Consolidated Financial Statements

(Unaudited)

 

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

 

Interactive Intelligence, Inc. (“I3” or the “Company”)is a leading provider of software-based interaction management solutionsdesigned to automate communications for contact centers, enterprises, andservice providers. Based on an open, unified platform, the InteractiveIntelligence product line was designed as a flexible and affordable alternativeto traditional telecom solutions. The Company’s products provide a completecommunications solution including PBX (private branch exchange), ACD (automatedcall distributor), IVR (interactive voice response), unified communications,and Internet and wireless functionality. The Company currently derives substantially all of its revenues fromlicenses of its Interaction Center Platform products and related services.

 

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

 

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

 

The balance sheet atDecember 31, 2002 has been derived from the audited financial statements atthat date but does not include all of the information and footnotes required bygenerally accepted accounting principles for complete financial statements.

 

These financialstatements should be read in conjunction with our audited consolidatedfinancial statements for the year ended December 31, 2002, included in theCompany’s Form 10-K for the year ended December 31, 2002, filed with theSecurities and Exchange Commission on March 31, 2003.  Our results of operations for any interim period are notnecessarily indicative of the results of operations for any other interimperiod or for a full fiscal year.

 

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

 

Basic net loss per shareis calculated based on the weighted-average number of outstanding commonshares.  Diluted net loss per share iscalculated based on the weighted-average number of outstanding common sharesplus the effect of dilutive potential common shares.  Potential common shares are composed of shares of common stock ofthe Company issuable on the exercise of stock options.  When potential common shares are dilutive,the treasury stock method is used to compute the common equivalent shares.  Under the treasury stock method, the assumedproceeds from the exercise of stock options are applied solely to therepurchase of common stock.

 

6

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

 
|                                                 |   | **Three Months Ended  June 30,** |   | **Six Months Ended  June 30,** |   |
|------------------------------------------------------|--------|----------------------------------|--------|--------------------------------|--------|
|                                                 |   | **2003**                         |   | **2002**                       |   | **2003** | ** ** | **2002** | ** ** |
|                                                 |   |                             |   |                           |   |   |   |   |   |
| Net  loss                                            |   | $                                | (3,900 | )                              | $      | (1,859 | ) | $ | (3,600 | ) | $ | (4,093 | ) |
|                                                 |   |                             |   |                           |   |   |   |   |   |
| Basic  and diluted:                                  |   |                             |   |                           |   |   |   |   |   |
| Weighted  average outstanding shares of common stock |   | 15,600                           |   | 15,398                         |   | 15,582 |   | 15,368 |   |
|                                                 |   |                             |   |                           |   |   |   |   |   |
| Basic  and diluted net loss per common share         |   | $                                | (0.25  | )                              | $      | (0.12 | ) | $ | (0.23 | ) | $ | (0.27 | ) |

 

The Company’s calculationof diluted net loss per share excludes all potential common shares as theeffect would be antidilutive.  Optionsto purchase 3,510,041 shares of common stock with exercise prices of $0.13 to$50.50 per share were outstanding as of June 30, 2003 and options to purchase3,205,447 shares of common stock with exercise prices of $0.13 to $50.50 pershare were outstanding as of June 30, 2002.

 

**3.****                   Stock-Based Compensation**

 

The Company accounts forits stock option plans in accordance with Statement of Financial AccountingStandards No. 123, *Accounting forStock-Based Compensation*(“SFAS 123”)**and uses the intrinsic value method under APB Opinion No.25, *Accounting for Stock Issued toEmployees,* and related Interpretations.  The majority of options granted to employees under these planshad an exercise price equal to the market value of the underlying common stockon the date of grant.  The tableincluded below illustrates the effect on the net loss and loss per share if theCompany had applied the fair value recognition provisions of SFAS 123 tostock-based employee compensation.

 

(*in thousands except per share amounts):*

 
|                                                                                                                                 |   | **Three  Months Ended  June 30,** |   | **Six Months  Ended  June 30,** |       |
|--------------------------------------------------------------------------------------------------------------------------------------|--------|-----------------------------------|--------|---------------------------------|------------|
|                                                                                                                                 |   | **2003**                          |   | **2002**                        | ** ** | **2003** | ** ** | **2002** | ** ** |
| Net  loss, as reported                                                                                                               |   | $                                 | (3,900 | )                               | $          | (1,859 | ) | $ | (3,600 | ) | $ | (4,093 | ) |
| Deduct:  Total stock-based compensation expense determined under fair value based  method for all awards, net of related tax effects |   | (1,381                            | )      | (1,339                          | )          | (2,770 | ) | (2,806 | ) |
|                                                                                                                                 |   |                              |   |                            |       |   |   |   |   |
| Pro  forma net loss                                                                                                                  |   | $                                 | (5,281 | )                               | $          | (3,198 | ) | $ | (6,370 | ) | $ | (6,899 | ) |
|                                                                                                                                 |   |                              |   |                            |       |   |   |   |   |
| Loss  per share:                                                                                                                     |   |                              |   |                            |       |   |   |   |   |
| Basic  and diluted - as reported                                                                                                     |   | $                                 | (0.25  | )                               | $          | (0.12 | ) | $ | (0.23 | ) | $ | (0.27 | ) |
| Basic  and diluted - pro forma                                                                                                       |   | $                                 | (0.34  | )                               | $          | (0.21 | ) | $ | (0.41 | ) | $ | (0.45 | ) |

 

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

 

Onecustomer  represented approximately 10%of total revenues for the six months ended June 30, 2003.

 

7

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**5.****                   Contingencies**

 

In June 1999 andSeptember 1999, the Company received letters from a competitor in the callcenter market claiming that the Company’s products utilize technologiespioneered and patented by that competitor. The Company’s patent counsel has reviewed all of the patents listed inthe letters.  Based on the advice of theCompany’s patent counsel, the Company believes that its products do notinfringe any of the patents listed in either letter.  The Company has discussed its conclusion with the competitor andhas also discussed possible licensing of certain technologies from thecompetitor.  Although the Company hasnot heard from this competitor since early 2001, the Company cannot assure youthat this matter can be resolved amicably without litigation, or that it willultimately be able to enter into a licensing arrangement on terms andconditions that would not have a material adverse effect on the Company’sbusiness, financial condition or results of operations.

 

In June 2000 and October 2001, the Company receivedletters from a competitor in the outbound call center market claiming that theCompany’s products utilize technologies pioneered and patented by thecompetitor.  Although the Company’spatent counsel has not determined the validity of these patents, the Companyhas discussed the possible licensing of certain technologies from thecompetitor.  Ownership of the technologyhas changed twice since the original letters. The Company cannot assure you that these claims can be resolved amicablywithout litigation, or that it will be able to enter into licensingarrangements on terms and conditions that would not have a material adverseeffect on the Company’s business, financial condition or results of operations.

 

In July 2002, the Companyreceived a letter from a consulting firm which has been retained by atelecommunication technology provider to develop and implement a licensingprogram based on the technology provider’s patents.  The consulting firm believes a licensing agreement between theCompany and the technology provider is appropriate.  The Company’s patent counsel is in the process of reviewing thepatents listed in the letter.  To date,the Company’s patent counsel has not determined the validity or applicabilityof these patents.  The Company has alsodiscussed the possible licensing of the technology provider’s patents with theconsulting firm.  The Company cannotassure you that this matter can be resolved amicably without litigation, orthat it will be able to enter into a licensing arrangement on terms andconditions that would not have a material adverse effect on the Company’sbusiness, financial condition or results of operations.

 

In December 2002, theCompany received a letter from one of its resellers requesting indemnificationrelated to a request that it had received for indemnification from an end userthat had received a letter from a third party indicating that the end user maybe infringing patents held by the third party. To date, the Company’s patent counsel has not determined the validity orthe applicability of these patents as they relate to the Company’s products orwhether the reseller is entitled to indemnification.  The Company cannot assure you that this claim for indemnificationcan be resolved favorably in a manner that would not have a material adverseeffect on the Company’s business, financial condition or results of operations.

 

Other third parties haveclaimed or may in the future claim that our technology infringes theirproprietary rights.Infringement claims, even if without merit, can be time consuming and expensiveto defend. A third party asserting infringement claims against us or ourcustomers with respect to our current or future products may require us toenter into costly royalty arrangements or litigation, or otherwise materiallyadversely affect us.

 

In November 2002, theCompany received a notification from the French government as a result of a taxaudit that had been conducted encompassing the years 1998, 1999, 2000 and2001.  This assessment claims varioustaxes are owed related to Value Added Tax (“VAT”) and corporation taxes inaddition to what has previously been paid and accrued.  The assessment related to VAT isapproximately 2.3 million Euros or approximately $2.6 million as of June 30,2003 and the assessment related to corporation taxes is approximately 300,000Euros or approximately $340,000 as of June 30, 2003.  Based primarily on advice from the Company’s tax counsel, the 

 

8

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Company currentlybelieves the possibility of the Company paying the assessment related to VAT tobe remote and the assessment related to corporation taxes to be reasonablypossible.  The Company is appealing theassessment, but cannot assure you this matter will be resolved withoutlitigation, that it will not take several years to resolve, or that the Companywill not have to pay some or all of the assessment.

 

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

 

**6.****                   Restructuring and Other Charges**

 

In February 2003, theCompany announced its plan to downsize and reorganize resources in Europe, theMiddle East, and the African (“EMEA”) region. The French office was significantly affected.  Of the 20 positions located in France, seven positions weretransferred to other EMEA offices, eight positions have been eliminated, twopositions remain to be eliminated and three positions remain in France.  For the three months ended June 30, 2003 andMarch 31, 2003, a total of $900,000 and $448,000, respectively was recognizedin accordance with Statement of Financial Accounting Standards No. 146, *Accounting for Costs Associated with Exit or DisposalActivities*(“SFAS 146”) as restructuring and other charges.  Of the total amount, approximately $577,000and $333,000 for the three months ended June 30, 2003 and March 31, 2003,respectively was related to severance and the remaining amount was related toprofessional and other fees.

 

The Company anticipatesadditional restructuring and other charges to be incurred in the second half of2003 related to the termination of two employees in France and additionalprofessional fees.  The Companyanticipates the remaining charge in the second half of 2003 related to the EMEAreorganization to range from $100,000 to $200,000.

 

Additionally, the Companymoved its world-wide headquarters to a new building in Indianapolis,Indiana.  Effective April 1, 2003, allIndianapolis-based employees, equipment and furniture were relocated to the newfacility.  The Company continues to owelease payments on the previous headquarters through March 1, 2004.  The Company determined that the remaininglease payments on the previous headquarters, net of sublease income, qualified asan exit cost and was recognized in accordance with  Statement of Financial Accounting Standards No. 146, *Accounting for Costs Associated with Exit or DisposalActivities*(“SFAS 146”) as restructuring and other charges.  For the three months ended June 30, 2003, atotal of $1.6 million was recognized. In addition, the Company wrote off approximately $220,000 in leaseholdimprovements related to the previous headquarters.  The Company does not anticipate any additional restructuring andother charges related to the relocation of its world-wide headquarters.

 

A summary of thebeginning accrued restructuring and other charges, expensed amount, cashpayments and the ending accrued restructuring and other charges is presentedbelow.

 
|                                   |   | **French  Operations** |    | **Worldwide  Headquarters** |   | **Total** |       |
|----------------------------------------|--------|------------------------|---------|-----------------------------|--------|-----------|------------|
|                                   |   |                   |    |                        |   |      |       |
| Beginning balance at December 31, 2002 |   | $                      | —  |                        | $      | —    |       | $ | — |   |
| Expensed amount                        |   | 1,350,000              |    | 1,788,000                   |   | $         | 3,138,000  |   |
| Payments                               |   | (900,000               | )       | (618,000                    | )      | $         | (1,518,000 | ) |
| Ending balance at June 30, 2003        |   | $                      | 450,000 |                        | $      | 1,170,000 |       | $ | 1,620,000 |   |

 

9

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**7.****                   RecentAccounting Pronouncements**

 

In April 2003, theFinancial Accounting Standards Board ("FASB") issued SFAS No. 149, *Amendment of Statement 133 on Derivative Instrumentsand Hedging Activities*.  SFASNo. 149 amends and clarifies accounting for derivative instruments, includingcertain derivative instruments embedded in other contracts, and for hedgingactivities under SFAS No. 133.  Inparticular, SFAS No. 149 clarifies under what circumstances a contract with aninitial net investment meets the characteristics of a derivative and when aderivative contains a financing component that warrants special reporting inthe statement of cash flows.  SFAS No.149 is generally effective for contracts entered into or modified after June30, 2003 and is not expected to have a material impact on the Company’sfinancial position or results of operations.

 

In May 2003, the FASBissued SFAS No. 150, *Accounting for CertainFinancial Instruments with Characteristics of both Liabilities and Equity*.  SFAS No. 150 establishes standards for howan issuer classifies and measures in its statement of financial positioncertain financial instruments with characteristics of both liabilities andequity.  It requires that an issuerclassify a financial instrument that is within the scope as a liability (or anasset in some circumstances) because that financial instrument embodies anobligation of the issuer.  SFAS No. 150is effective for financial instruments entered into or modified after May 31,2003, and otherwise is effective at the beginning of the first interim periodbeginning after June 15, 2003.  Thisstatement is not expected to have a significant impact on the Company’sfinancial position or results of operations.

 

# **Item 2**. Management’s Discussion and Analysis of Financial Condition and Resultsof Operations

 

*Forward-LookingInformation*

 

Certainstatements in this Form 10-Q contain “forward-looking” information (asdefined in Section 27A of the Securities Act of 1933, as amended andSection 21E of the Securities Exchange Act of 1934, as amended) thatinvolve risks and uncertainties which may cause actual results to differmaterially from those predicted in the forward-looking statements. Forward-lookingstatements can be identified by their use of such verbs as “expects,”“anticipates,” and “believes” or similar verbs or conjugations of such verbs.If any of our assumptions on which the statements are based prove incorrect orshould unanticipated circumstances arise, our actual results could materiallydiffer from those anticipated by such forward-looking statements. Thedifferences could be caused by a number of factors or combination of factors,including, but not limited to, the “Factors Affecting Operating Results”described herein and the Risk Factors described in our Securities and ExchangeCommission filings, including the Form 10-K filing for the year endedDecember 31, 2002.

* *

*Overview*

 

     We commenced operations inOctober 1994. Through the end of 1996, we focused primarily on researchand development activities. Our first product was released in March 1997.In 1997 and 1998, we expanded our operations to capitalize on the increasedmarket demand for communications and interaction management software. Wedecided, at the expense of profitability, to continue investing significantlyin research and development, and to accelerate our investments in marketing,services and sales operations. We had no revenue in 1996, and our totalrevenues were $1.6 million in 1997, $9.0 million in 1998,$19.1 million in 1999, $27.3 million in 2000, $47.9 million in2001, $47.8 million in 2002 and $26.5 million for the six months endedJune 30, 2003. We cannot assure you that our revenues will grow in the future.

 

     Webelieve our investments in research and development and in marketing, servicesand sales operations will continue to be critical to any revenue growth weachieve. However, these investments have also significantly increased ouroperating costs and expenses, contributing to the net losses and operatinglosses that we have incurred in all quarters since our formation with theexception of the first quarter of 

 

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2003. In addition, we are likely to continue to experience losses andnegative cash flows from operations in future quarters. We cannot assure youwhen or if we will achieve profitability again or, if achieved, that we will beable to sustain profitability. Our operating results have varied significantlyfrom quarter to quarter and may continue to do so in the future. As a result,we believe that period-to-period comparisons of our operating results are notnecessarily meaningful, and you should not rely on them as an indication of ourfuture performance.

 

     As of June 30, 2003 we had incurredapproximately $2.7 million in charges related to the restructuring of ourEuropean operations (which was announced in February 2003) and relocation ofour worldwide headquarters.  Thesecharges related primarily to severance, professional services and ongoing leaseobligations.

 

*CriticalAccounting Policies and Estimates*

 

     We believe the accounting policies thatare related to revenue recognition, the allowance for doubtful accountsreceivable and contingencies are important to understanding our performance.These policies, which involve significant management judgment and estimates,and related procedures are described in detail below.

** **

**Sources of Revenues and Revenue Recognition Policy**

     The Company generates software revenuesfrom licensing the right to use its software products and generates servicesrevenues from annual license fees, ongoing maintenance (post-contract technicalsupport and unspecified product upgrades), educational services, and professionalservices.

     Our software license fees primarilyoriginate from the marketing efforts of our resellers, who are authorized toplace orders for software licenses with us on behalf of end-user customers. Weshare end-user customer software license fees with these resellers in varyingpercentages of our list price, according to the terms of their reselleragreements. In addition to generating software license fees indirectly throughresellers, we also receive some software license fees from end-user customersthat we contract with directly. Our software license agreements are eitherannually renewable or perpetual.

     For any revenues to be recognized from asoftware license agreement, the following criteria must be met:

•      persuasive evidence of an arrangementexists;

•      the fee is fixed or determinable;

•      collection is probable; and

•      delivery has occurred.

     Delivery is further defined in certainsoftware license agreements as delivery of the product master or first copy fornon-cancelable product licensing arrangements under which the recipient,typically a reseller, has certain software distribution rights. For theselicensing arrangements, the delivery criteria has been met when a binding orderfor a specified end-user customer is placed, as the reseller already possessesa product master copy and the Company has no further delivery obligations.

     Under our annually renewable licenseagreements, the initial reseller order or end-user contract includes both aninitial license fee and an annual renewal fee. Upon meeting the revenuerecognition criteria, we recognize a portion of the initial license fees underthese annually renewable license agreements as software revenues ratably overthe initial license period, which is generally twelve months.  Under our annually renewable licenseagreements, we also recognize annual renewal fees as services revenues ratablyover the term of the initial license period, which is generally twelve months.  The allocation of the initial order betweensoftware revenues (initial license fees) and services revenues (annual renewalfees) is based on actual renewal fee rates. After the initial license period, our end-user customers may renew theirlicense agreement for an additional annual period by paying an additionalannual renewal fee. If the annual renewal fee is not paid, the customer is nolonger entitled to use the software and we may terminate its license agreement.Payment of the annual renewal fee also entitles the customer to ongoingmaintenance (post-contract technical support and unspecified product upgrades)for the renewal period.  We recognizethese additional annual renewal fees as services revenues ratably over the termof the renewal period, which is also generally twelve months.

 

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     Under our perpetual license agreements,the initial reseller order or end-user contract includes both an initiallicense fee and an annual maintenance fee. Upon meeting the revenue recognitioncriteria, we immediately recognize the entire amount of initial license feesunder these perpetual license agreements as software revenues if sufficientvendor specific objective evidence exists to support allocating a portion ofthe total fee to the undelivered elements of the arrangement. If sufficientvendor specific objective evidence of the undelivered elements does not exist,we typically recognize the initial license fee ratably over the initial term,which is generally twelve months.

     Under our perpetual license agreements,we also recognize annual maintenance fees as services revenues ratably over thepost-contract maintenance period, which is typically twelve months. Ourend-user customers may renew their maintenance term for an additional one-yearperiod by paying an additional maintenance fee. We recognize these additionalmaintenance fees as services revenues ratably over the term of the renewalperiod, which is also generally twelve months. Payment of the annualmaintenance fee entitles the customer to ongoing maintenance (post-contracttechnical support and unspecified product upgrades).

     We share annual renewal fees and ongoingmaintenance fees with those resellers who provide initial technical support toend-user customers according to the terms of their reseller agreements. Whenthese revenues are shared with resellers, we typically receive between 50% and70% of the amount charged by the reseller to the end-user customer.

     We also generate revenues from otherservices that we provide to our resellers and end-user customers. In additionto annual renewal fees and ongoing maintenance fees, services revenues includeeducational services and professional services. Revenues from educationalservices, which consist of training courses for resellers and end-usercustomers, and professional services, which include implementing andcustomizing our products for an end-user customer, are typically recognized asthe related services are performed.

 

**Allowancefor Doubtful Accounts Receivable**

 

     We record our allowance for doubtfulaccounts for each reporting period based on a detailed analysis of our accountsreceivable at the end of that period. In estimating the allowance for doubtfulaccounts, we primarily consider the age of the customer’s accounts receivable andalso consider the creditworthiness of the customer, the economic conditions ofthe customer’s industry, and general economic conditions, among other factors.Should any of these factors change, the estimates made by us will also change,which could impact the level of our future allowance for doubtful accounts.Specifically, if the financial condition of our customers were to deteriorate,affecting their ability to make payments, increases to allowances for doubtfulaccounts may be required.

 

*HistoricalResults of Operations*

 

Thefollowing table presents certain financial data, derived from our unauditedstatements of operations, as a percentage of total revenues for the periodsindicated. The operating results for the three months and six months ended June30, 2003 and 2002 are not necessarily indicative of the results that may beexpected for the full year or for any future period.

 

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|                               |   | **Three  Months Ended  June 30,** |   | **Six  Months Ended  June 30,** |       |
|------------------------------------|--------|-----------------------------------|--------|---------------------------------|------------|
|                               |   | **2003**                          |   | **2002**                        | ** ** | **2003** | ** ** | **2002** | ** ** |
|                               |   |                              |   |                            |       |   |   |   |   |
| Revenues:                          |   |                              |   |                            |       |   |   |   |   |
| Software                           |   | 48                                | %      | 64                              | %          | 54 | % | 64 | % |
| Services                           |   | 52                                |   | 36                              |       | 46 |   | 36 |   |
| Total  revenues                    |   | 100                               |   | 100                             |       | 100 |   | 100 |   |
|                               |   |                              |   |                            |       |   |   |   |   |
| Costs  and expenses:               |   |                              |   |                            |       |   |   |   |   |
| Costs  of software                 |   | 3                                 |   | 2                               |       | 2 |   | 2 |   |
| Costs  of services                 |   | 27                                |   | 24                              |       | 24 |   | 24 |   |
| Sales  and marketing               |   | 41                                |   | 43                              |       | 38 |   | 45 |   |
| Research  and development          |   | 29                                |   | 31                              |       | 26 |   | 32 |   |
| General  and administrative        |   | 11                                |   | 11                              |       | 11 |   | 12 |   |
| Restructuring  charges             |   | 22                                |   | 6                               |       | 12 |   | 3 |   |
| Total  costs and expenses          |   | 133                               |   | 117                             |       | 113 |   | 118 |   |
|                               |   |                              |   |                            |       |   |   |   |   |
| Operating  income (loss)           |   | (33                               | )      | (17                             | )          | (13 | ) | (18 | ) |
| Interest  income, net              |   | —                            |   | 1                               |       | — |   | 1 |   |
| Income  (loss) before income taxes |   | (33                               | )      | (16                             | )          | (13 | ) | (17 | ) |
| Income  taxes                      |   | —                            |   | —                          |       | — |   | — |   |
| Net  income (loss)                 |   | (33                               | )%     | (16                             | )%         | (13 | )% | (17 | )% |

 

*Revenues*

 

     Our total revenues were  $12.1 million for both the three monthsended June 30, 2002 and June 30, 2003. Total revenues increased 10% from $24.1 million for the six months endedJune 30, 2002, to $26.5 million for the six months ended June 30, 2003.  Non-North American revenues remainedconstant at $1.9 million for the three months ended June 30, 2002 and June30, 2003 and decreased from $4.3 million to $4.0 million for the six monthsended June 30, 2002 and June 30, 2003, respectively.  Our revenues are derived from software license fees and chargesfor services, including annual license fees and ongoing maintenance fees,education services, and professional services. The relative amount of servicesrevenues in the 2003 periods increased compared to the 2002 periods primarilyas a result of increased annual license and ongoing maintenance fees from ourgrowing customer base.  The increase intotal revenues for the six month period in 2003 compared to 2002 resulted fromthese higher services revenues being offset by slightly lower softwarerevenues.

 

*     Software.*  Oursoftware revenues decreased 25% from $7.7 million for the three monthsended June 30, 2002, to $5.8 million for the three months ended June 30,2003. Software revenues decreased 6% from $15.3 million for the six monthsended June 30, 2002, to $14.4 million for the six months ended June30, 2003.   We believe the decrease insoftware revenues resulted from a weak economic environment, causing many ofour customers and prospective customers to delay and/or reduce their capitalspending and related professional services. We continue to expect the remainder of 2003 to be a challenging salesenvironment for capital investments. Factors that could impact our software revenues and deferred softwarerevenues in the remainder of 2003 compared to 2002 include whether we canincrease the amount of our enterprise product licenses (e.g., CommunitéTM andEnterprise Interaction Center®), the license mix of perpetual compared toannually renewable licenses, and seasonality, which is typically weightedtoward the end of a calendar year.

 

*     Services.*  Servicesrevenues increased 43% from $4.4 million for the three months ended June30, 2002, to $6.3 million for the three months ended June 30, 2003.Services revenues increased 38% from $8.8 million for the six months ended June30, 2002, to $12.1 million for the six months ended June 30, 2003.  The increase in services revenues in both2003 periods was primarily due to an increase in annual license fees andongoing maintenance fees, both of which are related to our growing installedbase of end-user customers.  To a lesserextent, we also saw growth in revenues from professional services.  As we add more customers and focus onservicing our existing customer base, we believe we may be able to continue togrow our services revenues.

 

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*Costand Expenses*

 

     Our total costs and expenses increased14% from $14.0 million for the three months ended June 30, 2002 to$16.0 million for the three months ended June 30, 2003.  Total costs and expenses increased 6% from$28.3 million for the six months ended June 30, 2002 to $30.1 million forthe six months ended June 30, 2003.  Theincrease for both periods related mainly to an increase in restructuring andother charges, which for the six month periods of 2002 compared to 2003 werepartially offset by lower sales and marketing, and research and developmentexpenses.

* *

*      Costs of Software.*  Costsof software consist primarily of product royalties paid to third-parties forthe use of their technologies in our products and, to a lesser extent, softwarepackaging costs, which include product media, duplication and documentation.Costs of software increased from $192,000 for the three months ended June 30,2002 to $325,000 for the three months ended June 30, 2003.  Costs of software increased from $464,000for the six months ended June 30, 2002, to $617,000 for the six months endedJune 30, 2003.  This representsapproximately 2% and 6% of software revenues for the three months ended June30, 2002 and June 30, 2003, respectively, and 3% and 4% for the six monthsended June 30, 2002 and June 30, 2003, respectively. The slight dollar increasewas primarily attributable to the recognition of product royalties related tosoftware revenues we also recognized during the period.  Although software revenues decreased for thethree and six months ended June 30, 2002 to June 30, 2003, costs of softwareincreased because of the specific contracts and related royalties beingrecognized during the periods.

* *

*      Costs of Services.*  Costsof services consist primarily of compensation expenses for technical support,education, and professional services personnel and other costs associated withsupporting our resellers and end-user customers. Costs of services increasedfrom $2.9 million for the three months ended June 30, 2002, to$3.3 million for the three months ended June 30, 2003.  Costs of services increased from $5.9million for the six months ended June 30, 2002, to $6.4 million for the sixmonths ended June 30, 2003. As a percentage of services revenues, cost of services represented 65%and 51% for the three months ended June 30, 2002 and 2003, respectively,and 67% and 53% for the six months ended June 30, 2002 and June 30, 2003.  The dollar increase was primarily a resultof increased services revenues and the need to continue to support the growingcustomer base.  The decrease of cost ofservices as a percent of services revenue was related to continued operatingefficiencies being realized by our support, education, and professionalservices resources as our customer base grows. While we anticipate that costs of services will increase as we add morecustomers and services our existing customer base, we also currently believethere is a continued opportunity for costs of services to slightly decline as apercentage of services revenues.

* *

*     Sales and Marketing.*  Salesand marketing expenses primarily consist of compensation expenses (includingsales commissions), travel expenses, trade shows, telemarketing campaigns,public relations and other promotional expenses.  Sales and marketing expenses decreased from $5.2 million forthe three months ended June 30, 2002 to $4.9 million for the three months endedJune 30, 2003.  This decrease wasprimarily the result of reduced sales commissions associated with lowersoftware revenues.  Sales and marketingexpenses decreased from $10.7 million for the six months ended June 30, 2002,to $10.1 million for the six months ended June 30, 2003.  This decrease was primarily the result ofreduced compensation and discretionary marketing expenditures following theimplementation of our 2002 restructuring plans, and somewhat lower variablecompensation expenses associated with lower software revenues.  We expect sales and marketing expenses inthe remainder of 2003 to vary from 2002 primarily by variable compensationexpenses.  We will add sales andmarketing personnel and increase sales and marketing efforts if performance dictatesand/or attractive opportunities present themselves in the remainder of 2003.

* *

*     Research and Development.*  Researchand development expenses consist primarily of compensation expenses for ourdevelopers and, to a lesser extent, third party efforts to develop new productsand enhance existing products, including adapting our products for specificnon-English languages and allowing our products to effectively run withalternative hardware configurations. Research and development expenses decreased from $3.7 million forthe three months ended June 30, 2002 to $3.5 million for the three months endedJune 30, 2003. Research and development expenses decreased from $7.6 millionfor the six months ended June 30, 2002, to $7.0 million for the six months endedJune 30, 2003.  The decrease was aresult of the implementation of our 2002 and 2003 restructuring plans, shiftingsome resources from research and 

 

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development to services,and slightly lower depreciation expense. Currently, all costs related to research and development of our productsare charged to research and development expense as incurred.

 

*General and Administrative.*  Generaland administrative expenses consist primarily of compensation for ouradministrative, financial, and information technology personnel, and a numberof non-allocable costs, including bad debt, legal and other professionalservice fees. General and administrative expenses remained constant at$1.4 million for the three months ended June 30, 2002 and June 30,2003.  General and administrativeexpenses decreased slightly from $2.9 million for the six months ended June 30,2002, to $2.8 million for the six months ended June 30, 2003.  We believe our general and administrative expenseswill remain constant or be slightly higher in the remainder of 2003 over 2002due to increased costs from our new headquarters building.

 

*     Restructuring and Other Charges.*For the three months ended June 30, 2003, we incurred $2.7 million in restructuringand other charges related to the restructuring of our European operations andrelocation of our worldwide headquarters. In February 2003, the Company announced its plan to downsize andreorganize resources in Europe, the Middle East, and the African (“EMEA”)region.  The French office wassignificantly affected.  Of the 20positions located in France, seven positions were transferred to other EMEAoffices, eight positions have been eliminated, two positions remain to beeliminated and three positions remain in France.  For the three months ended June 30, 2003, a total of $900,000 wasrecognized in accordance with Statement of Financial Accounting Standards No.146, *Accounting for Costs Associated withExit or Disposal Activities*(“SFAS 146”) as restructuring and othercharges.  Of the total amount,approximately $577,000 was related to severance and the remaining amount wasrelated to professional and other fees.

 

     The Company anticipates additionalrestructuring and other charges to be incurred in the second half of 2003related to the termination of the two remaining employees in France andadditional professional fees.  TheCompany anticipates the remaining charge in the second half of 2003 related tothe EMEA reorganization to range from $100,000 to $200,000.

 

     Additionally, the Company moved itsworld-wide headquarters to a new building in Indianapolis, Indiana.  Effective April 1, 2003, allIndianapolis-based employees, equipment and furniture were relocated to the newfacility.  The Company continues to owelease payments on the previous headquarters through March 1, 2004.  The Company determined that the remaininglease payments on the previous headquarters, net of sublease income, qualified asexit costs and were recognized in accordance with  Statement of Financial Accounting Standards No. 146, *Accounting for Costs Associated with Exit or DisposalActivities*(“SFAS 146”) as restructuring and other charges.  For the three months ended June 30, 2003, atotal of $1.6 million was recognized. In addition, we wrote off approximately $220,000 in leaseholdimprovements related to the previous headquarters.

 

*Interestincome, net*

 

     Interest income, net decreased from$104,000 for the three months ended June 30, 2002 to $43,000 for the threemonths ended June 30, 2003.  Interestincome, net decreased from $233,000 for the six months ended June 30, 2002, to$96,000 for the six months ended June 30, 2003.  Both decreases resulted from a combination of a decrease ininterest rates and less invested cash.

 

*Incometaxes*

 

     For U.S. corporate income tax purposes,we did not recognize a tax benefit related to U.S. federal or state incometaxes during the three or six months ended June 30, 2002 or June 30, 2003because of the uncertainty of eventually realizing the benefits of ouroperating losses. However, we did recognize tax expense related to ourinternational operations of $60,000 and $43,000 for the three months ended June30, 2002, and June 30, 2003, respectively, and tax expense of $129,000 and$96,000 for the six months ended June 30, 2002 and June 30, 2003, respectively.

 

Asdescribed in Note 5 of our Notes to the Condensed Consolidated FinancialStatements, we have received a notification from the French government as aresult of a tax audit that had been conducted 

 

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encompassing the years1998, 1999, 2000, and 2001.  The totalassessment is approximately 2.6 million Euros or approximately $3.0million.  We are appealing theassessment, but cannot assure you that this matter will be resolved withoutlitigation, that it will not take several years to resolve or that we will nothave to pay some or all of the assessment.

 

*Liquidityand Capital Resources*

 

As ofJune 30, 2003, we had cash and cash equivalents of $12.1 million,$3.1 million in short term investments and a working capital deficit of$2.4 million.  Excluding liabilitiesrelated to deferred revenues of $20.7 million from the working capitalcalculation, we have a working capital balance of $18.3 million.

 

Ouroperating activities resulted in a net cash inflow of $2.0 million for thesix month period ended June 30, 2003, and a net cash outflow of$3.1 million for the six month period ended June 30, 2002. The netoperating cash inflow for the first six months of 2003 was primarily the resultof our net loss, offset by non-cash depreciation, a decrease in accountsreceivable and restructuring and other charges.  The net operating cash outflow for the first six months of 2002was primarily the result of our operating loss and a decrease in deferredrevenues, partially offset by the non-cash depreciation amount.

 

Ourinvesting activities have consisted primarily of capital expenditures forproperty and equipment and purchases and sales of investments. Our investingactivities resulted in a $3.9 million inflow for the six month period endedJune 30, 2003 and a $6.5 million outflow for the six month period endedJune 30, 2002. The inflow for the first six months of 2003 was attributed to thenet sale of available-for-sale investments, partially offset by capitalexpenditures for property and equipment. The net outflow for the first sixmonths of 2002 was attributable to net purchases of available-for-saleinvestments and capital expenditures for property and equipment.  At June 30, 2003, except for some possibleexpenditures for subleasing the first floor of our world-wide headquarters andsome additional leasehold improvements, we do not have any material commitmentsfor future capital expenditures.

 

InApril 2001, we entered into a non-cancelable operating lease agreement for anew, approximately 120,000 square foot corporate headquarters building that wemoved into in April 2003.  Over the lifeof the 15 year lease, we are committed to expend approximately $35.1 million inrent payments.

 

As ofApril 2003, we had approximately 78,000 square feet of unused office facilitiesrelated to our prior headquarters and associated facilities which we continueto market for sublease.  As the overallsublease market is difficult and we have less than one year left on thesubstantial majority of these leases, we believe it is not probable that oursublease efforts will be successful. The Company determined that the remaining lease payments on the previousheadquarters, net of sublease income, qualified as exit costs and wererecognized in accordance with  Statementof Financial Accounting Standards No. 146, *Accountingfor Costs Associated with Exit or Disposal Activities*(“SFAS 146”)as restructuring and other charges.  Forthe three months ended June 30, 2003, a total of $1.6 million wasrecognized.  In addition, we wrote offapproximately $220,000 in leasehold improvements related to the relocation ofour headquarters.

 

     For the six months ended June 30, 2003,we generated $169,000 from financing activities, which was entirelyattributable to the issuance of common stock. For the six months ended June 30, 2002 we generated $357,000, which wasrelated to both the issuance of common stock and stock option exercises.

 

     We believe that our existing cash andcash equivalents and short-term investments will be sufficient to meet ourworking capital and capital expenditure requirements for at least the next12 months. After that time, we may require additional funds to support ourworking capital requirements or for other corporate purposes, and we may seekto raise additional funds through public or private equity or debt financingsor from other sources. We cannot assure you that additional financing will beavailable at all or that, if available, it will be on terms favorable to us orthat any additional financing will not dilute your ownership interest in theCompany.

 

*RecentlyIssued Accounting Standards*

 

     In April 2003, the FASB issued SFAS No. 149,*Amendment of Statement 133 on DerivativeInstruments and Hedging Activities*. SFAS No. 149 amends andclarifies accounting for derivative instruments, including certain derivativeinstruments embedded in other contracts, and for hedging activities under SFASNo. 133. In particular, SFAS No. 149 clarifies under what circumstances acontract with an initial net investment meets the characteristics of aderivative and when a derivative contains a financing component that warrantsspecial reporting in the statement of cash flows. SFAS No. 149 is generallyeffective for contracts entered into or modified after June 30, 2003 and is notexpected to have a material impact on the Company's financial position orresults of operations.

 

     In May 2003, the FASB issued SFAS No.150, *Accounting for Certain FinancialInstruments with Characteristics of both Liabilities and Equity*.SFAS No. 150 establishes standards for how an issuer classifies and measures inits statement of financial position certain financial instruments withcharacteristics of both liabilities and equity. It requires that an issuerclassify a financial instrument that is within the scope as a liability (or anasset in some circumstances) because that financial instrument embodies anobligation of the issuer. SFAS No. 150 is effective for financial instrumentsentered into or modified after May 31, 2003, and otherwise is effective at thebeginning of the first interim period beginning after June 15, 2003. Thisstatement is not expected to have a significant impact on the Company'sfinancial position or results of operations.

 

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

 

**THEOVERALL ECONOMIC CLIMATE CONTINUES TO BE WEAK**

 

Ourproducts typically represent substantial capital commitments by customers,involving a potentially long sales cycle. As a result, customer purchasedecisions may be significantly affected by a variety of factors, includinggeneral economic trends in the allocation of capital spending budgets forcommunication software, services and systems, lengthened sales cycles, customerapproval processes, and market conditions, which have resulted in many of ourcustomers delaying and/or reducing their capital spending related toinformation systems. If the economy continues to be weak, demand for ourproducts could decrease, resulting in lower revenues.

 

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

 

Sinceinception, the first quarter of 2003 is the only quarter we have beenprofitable. We incurred net losses of $7.7 million, $11.0 million,and $15.1 million in 2002, 2001, and 2000, respectively. At June 30, 2003,we had accumulated net losses since inception of $59.1 million. We intendto continue to make significant investments in our research and development,marketing, services and sales operations. These expenses could precede anyrevenues generated by this spending. As a result, we are likely to continue toexperience losses and negative cash flow from operations in futurequarters.  

 

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

 

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

 

Becausewe do not know if or when our potential end-user customers will place ordersand finalize licenses, and because it is difficult to predict the mix ofannually renewable licenses and perpetual licenses in a quarter, we cannotaccurately forecast our licensing activity, our revenues and our operatingresults for future quarters. We recognize revenues from different licenses overdifferent periods on satisfaction of the requirements of relevant accountingliterature, including AICPA Statement of Position 97-2, Statement of Position98-9, SEC Staff Accounting Bulletin (SAB) 101, and all related AICPA TechnicalPractice Aids (5100.38 - 5100.76). As a result, our quarterlyrevenues and operating results depend on many factors, including the type oflicense, and the size, quantity and timing of orders received for our productsduring each quarter. If a large number of orders or several large orders do notoccur or are deferred or delayed, our revenues in a quarter could besubstantially reduced. This risk is heightened by the significant investmentand executive level decision-making typically involved in our end-usercustomers’ decisions to license our products. Since a large portion of ouroperating expenses, including rent and salaries, is fixed and difficult toreduce or modify, our business, financial condition or results of operationscould be materially adversely affected if revenues do not meet ourexpectations.

 

Becauseof our limited number of products, changes in pricing policies and the timingof the development, announcement and sale of new or upgraded versions of ourproducts are some of the additional factors that could cause our revenues andoperating results to vary significantly from quarter to quarter.

 

**WEHAVE A LENGTHY PRODUCT SALES CYCLE, WHICH HAS CONTRIBUTED, AND MAY CONTINUE TOCONTRIBUTE, TO THE QUARTER-TO-QUARTER VARIABILITY OF OUR REVENUES AND OPERATINGRESULTS, WHICH COULD AFFECT THE MARKET PRICE OF OUR COMMON STOCK**

 

Wehave generally experienced a lengthy product sales cycle, averagingapproximately six to nine months. The lengthy sales cycle is one of the factorsthat has caused, and may in the future continue to 

 

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cause, our softwarerevenues and operating results to vary significantly from quarter to quarter,which could affect the market price of our common stock. It also makes itdifficult for us to forecast product license revenues. Because of the uniquecharacteristics of our products, our prospective end-user customers’ decisionsto license our products often require significant investment and executivelevel decision making. We believe that many companies currently are not awareof the benefits of interaction management software of the type we license or ofour products and capabilities. For this reason, we must provide a significantlevel of education to prospective end-user customers about the use and benefitsof our products, which can cause potential end-user customers to take manymonths to make these decisions. As a result, sales cycles for end-user customerorders vary substantially from customer to customer. Excessive delay in productsales could materially adversely affect our business, financial condition orresults of operations.

 

Thelength of the sales cycle for end-user customer orders depends on a number ofother factors over which we have little or no control, including:

 

•                       anend-user customer’s budgetary constraints;

•                       thetiming of an end-user customer’s budget cycles;

•                       concernsby end-user customers about the introduction of new products by us or ourcompetitors; and

•                       downturnsin general economic conditions, including reductions in demand for call centerservices.

 

In addition, the salescycle for our products in international markets has been, and is expected tocontinue to be, longer than the sales cycle in the United States. The averagesales cycle for our products may lengthen as we expand internationally.

** **

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

 

As thecomplexity of our product technology and our reseller and other third-partyrelationships have increased, the management of those relationships and thenegotiation of contractual terms sufficient to protect our rights and limit ourpotential liabilities has become more complicated, and we expect this trend tocontinue in the future. As a result, our inability to successfully manage theserelationships or negotiate sufficient contractual terms could have a materialadverse effect on us.

** **

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

 

Themarket for our software products is highly competitive and, because there arerelatively low barriers to entry in the software market, we expect competitionto increase significantly in the future. In addition, because our industry isnew and evolving and characterized by rapid technological change, it isdifficult for us to predict whether, when and by whom new competingtechnologies or new competitors may be introduced into our markets. Currently,our competition comes from several different market segments, includingcomputer telephony platform developers, computer telephony applicationssoftware developers and telecommunications equipment vendors. We cannot assureyou that we will be able to compete effectively against current and futurecompetitors. In addition, increased competition or other competitive pressuresmay result in price reductions, reduced margins or loss of market share, any ofwhich could have a material adverse effect on our business, financial conditionor results of operations.

 

Manyof our current and potential competitors have longer operating histories,significantly greater financial, technical, marketing, customer service andother resources, greater name recognition and a larger installed base ofcustomers than we do. As a result, these competitors may be able to respond tonew or emerging technologies and changes in customer requirements faster andmore effectively than we can, or to devote greater resources to thedevelopment, promotion and sale of products than we can. Current and potentialcompetitors have established, and may in the future establish, cooperativerelationships among themselves or with third parties, including mergers oracquisitions, to increase the ability of their products 

 

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to address the needs ofour current or prospective end-user customers. If these competitors were toacquire significant market share, it could have a material adverse effect onour business, financial condition or results of operations.

** **

**WEMAY NOT BE ABLE TO GROW OUR BUSINESS IF WE DO NOT MAINTAIN SUCCESSFUL RELATIONSHIPSWITH OUR RESELLERS AND OEM PARTNERS AND CONTINUE TO RECRUIT AND DEVELOPADDITIONAL SUCCESSFUL RESELLERS AND OEM PARTNERS**

 

Ourability to achieve revenue growth in the future will depend in part on oursuccess in maintaining successful relationships with our existing and futureresellers and OEM partners and in recruiting and training additional resellersand OEM partners. We rely primarily on resellers to market and support ourproducts and plan on continuing to rely heavily on such partners in the future.We are still developing our reseller and OEM distribution networks and may beunable to attract additional resellers with both voice and data expertise orappropriate OEM partners that will be able to market our products effectivelyand that will be qualified to provide timely and cost-effective customersupport and service. We generally do not have long-term or exclusive agreementswith our resellers or OEM partners, and the loss of specific larger resellersor OEM partners or a significant number of resellers or OEM partners couldmaterially adversely affect our business, financial condition or results ofoperations.

 

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

 

Themarket for our products is characterized by rapid technological change,frequent new product introductions and enhancements, uncertain product lifecycles and changing end-user customer demands. The introduction of productsembodying new technologies and the emergence of new industry standards couldrender existing products obsolete or unmarketable and cause us to incursignificant development costs.

** **

**THEGROWTH OF OUR BUSINESS MAY BE IMPEDED WITHOUT INCREASED USE OF THE  INTERNET**

 

Theuse of the Internet as a commercial marketplace is at an early stage ofdevelopment. Demand and market acceptance for recently introduced products andservices available over the Internet are still uncertain. In addition,governmental regulation of the Internet, such as imposing sales and othertaxes, access charges, and pricing controls and inhibiting cross-bordercommerce, may reduce the use of the Internet by businesses for their electroniccommerce and customer service needs. To date, governmental regulations have notmaterially restricted commercial use of the Internet. However, the legal andregulatory environment that pertains to the Internet is uncertain and maychange. New regulations could reduce the use of the Internet by our end-usercustomers and, in turn, their customers. The lack of acceptance of the Internetas a forum for conducting business could reduce growth in demand for ourproducts and limit the growth of our revenues.

 

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

 

Ourproducts address a market for Web-based, interactive electronic businesssolutions. Therefore, our future success depends on the widespread adoption ofthe Web as a primary medium for commerce and business applications. The failureof this market to expand, or a delay in the development of this market, couldhave a material adverse effect on our business, financial condition or resultsof operations. The Web has experienced, and is expected to continue toexperience, significant user and traffic growth, which has, at times, causeduser frustration with slow access and download times. The Web infrastructuremay not be able to support the demands placed on it by the continued growth onwhich our success depends. Moreover, critical issues concerning the commercialuse of the Web, such as security, reliability, cost, accessibility and qualityof service, remain unresolved and may negatively affect the growth of Web useor the attractiveness of commerce and business communication over the Web. Inaddition, the Web could lose its 

 

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viability due to delaysin the development or adoption of new standards and protocols to handleincreased activity or due to increased government regulation and taxation ofInternet commerce.

 

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

 

Ourproducts currently run only on Microsoft Windows operating systems. Inaddition, our products use other Microsoft Corporation technologies, includingMicrosoft Exchange Server® and Microsoft SQL Server®. A decline in marketacceptance for Microsoft technologies or the increased acceptance of other servertechnologies could cause us to incur significant development costs and couldhave a material adverse effect on our ability to market our current products.Although we believe that Microsoft technologies will continue to be widely usedby businesses, we cannot assure you that businesses will adopt thesetechnologies as anticipated or will not in the future migrate to othercomputing technologies that we do not currently support. In addition, ourproducts and technologies must continue to be compatible with new developmentsin Microsoft technologies.

 

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

 

Webelieve that our future business prospects depend in large part on our abilityto maintain and improve our current products and to develop new products on atimely basis. Our products will have to achieve market acceptance, maintaintechnological competitiveness and meet an expanding range of end-user customerrequirements. As a result of the complexities inherent in our products, majornew products and product enhancements require long development and testingperiods. We may not be successful in developing and marketing, on a timely andcost effective basis, product enhancements or new products that respond totechnological change, evolving industry standards or end-user customerrequirements. We may also experience difficulties that could delay or preventthe successful development, introduction or marketing of product enhancements,and our new products and product enhancements may not achieve marketacceptance. Significant delays in the general availability of new releases ofour products or significant problems in the installation or implementation ofnew releases of our products could have a material adverse effect on ourbusiness, financial condition or results of operations.

** **

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

 

If thedemand for interaction management software of the type we license does not growwithin each of our three targeted markets, our financial results and ability togrow our business could be materially adversely affected. All of our revenueshave been generated from licenses of our Interaction Center Platform® softwareor complementary products, and related support, educational and professionalservices. We expect these products and services to account for the majority ofour revenues for the foreseeable future. Although we believe demand for thefunctions performed by our products is high, the market for our products andservices is still emerging. Further, our growth plans require us tosuccessfully attract enterprise and service provider end-user customers insignificantly larger numbers than we have historically achieved.

** **

**IFOUR END-USER CUSTOMERS DO NOT PERCEIVE OUR PRODUCTS OR THE RELATED SERVICESPROVIDED BY US OR OUR RESELLERS OR OEM PARTNERS TO BE EFFECTIVE OR OF HIGHQUALITY, OUR BRAND AND NAME RECOGNITION WILL SUFFER**

 

Webelieve that establishing and maintaining brand and name recognition iscritical for attracting, retaining and expanding end-user customers in ourtarget markets. We also believe that the importance of reputation and namerecognition will increase as competition in our market increases. Promotion andenhancement of our name will depend on the effectiveness of our marketing andadvertising efforts and on our success in providing high-quality products and relatedservices, neither of which can be assured. If our 

 

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end-user customers do notperceive our products or related services to be effective or of high quality,our brand and name recognition would suffer which could have a material adverseeffect on our business, financial condition or results of operations.

 

**OURSERVICES REVENUES ARE DEPENDENT ON OUR INSTALLED BASE OF CUSTOMERS**

 

Wehave depended and will continue to depend on our installed customer base foradditional future revenues from services, including annual license fees andongoing maintenance fees. There can be no assurance that current installedcustomers will renew their licenses or pay ongoing maintenance fees in futureperiods. As a consequence, our operating results, cash flows and liquiditywould likely be adversely affected. Our failure to obtain new customers oradditional orders from existing customers could also materially affect ouroperating results.

 

**ANYDECREASE IN OUR LICENSING ACTIVITY IS LIKELY TO RESULT IN REDUCED SERVICESREVENUES IN FUTURE PERIODS**

 

Ourservices revenues are generated primarily from annual license fees, ongoingmaintenance (post-contract technical support and unspecified product upgrades),educational services, and professional services. A decrease in our servicesrevenues could follow a decrease in our licenses revenues. Our ability tomaintain or increase our services revenues depends in large part on our abilityto increase our software licensing activity.

 

**IFWE ARE UNABLE TO ADAPT OUR SOFTWARE IN A WAY THAT WILL PERMIT US TO SERVELARGE, SINGLE-SITE END-USER CUSTOMERS, THE MARKETABILITY OF OUR PRODUCTS COULDBE ADVERSELY AFFECTED**

 

Ourproducts cannot currently meet the communications needs of organizations withmore than 500 users at a single call center location. As these organizationsexpand to include multiple locations, our products can be customized toincrease the number of telephone lines, extensions and users. We will need toadapt our software to serve larger single-site organizations. Although we arecurrently developing and testing solutions that would enable our software tosignificantly increase the number of users that our products can serve at asingle location, we cannot assure you that we will be able to successfullyintroduce this technology into a currently available version of our products.Further, we may not be able to adapt our software in a timely or cost effectivemanner in a way that will permit us to serve these customers. This inabilitycould have a material adverse effect on our business, financial condition orresults of operations.

 

**OURMAIN SUPPLIERS OF VOICE PROCESSING BOARDS MAY BECOME UNWILLING OR UNABLE TOCONTINUE TO MANUFACTURE AND SUPPLY US WITH VOICE PROCESSING BOARDS, REQUIRINGUS TO INTRODUCE A SUBSTITUTE SUPPLIER WHICH COULD PROVE DIFFICULT OR COSTLY**

 

DialogicCorporation and AcuLab plc are our primary suppliers of the voice processingboards that are used by a majority of our end-user customers for the operationof our products. If a majority of future end-user customers desire to utilizethe voice processing boards to enable our products and these suppliers becomeunable or unwilling to continue to manufacture and supply these voiceprocessing boards in the volume, price and technical specifications we require,then we would have to adapt our products to a substitute supplier. We may notbe able to successfully introduce voice processing boards made by a substitutesupplier into the available versions of our products. In addition, introducinga substitute supplier of voice processing boards could result in unforeseenadditional product development or customization costs and could also introducehardware and software operating or compatibility problems. We cannot assure youthat these issues will not affect product shipments, will not be costly tocorrect, will not damage our reputation in the markets in which we operate, orwill not have a material adverse affect on our business, financial condition orresults of operations.

 

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

 

Weregard our software products as proprietary. In an effort to protect ourproprietary rights, we rely primarily on a combination of copyright, trademarkand trade secret laws, as well as patents, licensing and other agreements withconsultants, suppliers, strategic and OEM partners, resellers and end-usercustomers, and employee and third-party non-disclosure agreements. These lawsand agreements provide only limited protection of our proprietary rights. Inaddition, we have not signed agreements containing these types of protective provisionsin every case, and the contractual provisions that are in place and theprotection they provide vary and may not provide us with adequate protection inall circumstances. We currently hold three patents and have filed numerousother patent applications relating to technology embodied in our softwareproducts. We hold 17 U.S. trademark registrations and 26 foreign trademarkregistrations  and have numerous othertrademark applications pending worldwide, as well as having common law rightsin other trademarks and service marks. We hold one registered copyright.Because our means of protecting our proprietary rights may not be adequate, itmay be possible for a third party to copy or otherwise obtain and use ourtechnology without authorization. A third party could also develop similartechnology independently. In addition, the laws of some countries in which wesell our products do not protect our software and intellectual property rightsto the same extent as the laws of the United States. Unauthorized copying, useor reverse engineering of our products could materially adversely affect ourbusiness, results of operations or financial condition.

 

Welicense technology that is embedded in our products from others. If one or moreof these licenses terminates or cannot be renewed on satisfactory terms, wewould have to modify the affected products to use alternative technology oreliminate the affected product function, either of which could have a materialadverse effect on us.

 

**INFRINGEMENTCLAIMS COULD ADVERSELY AFFECT US**

 

InJune 1999 and September 1999, we received letters from a competitorin the call center market claiming that our products utilize technologiespioneered and patented by that competitor. Our patent counsel has reviewed allof the patents listed in the letters. Based on the advice of our patentcounsel, we believe that our products do not infringe any of the patents listedin either letter. We have discussed our conclusion with the competitor and havealso discussed possible licensing of certain technologies from the competitor.Although we have not heard from this competitor since early 2001, we cannotassure you that this matter can be resolved amicably without litigation, orthat we will ultimately be able to enter into a licensing arrangement on termsand conditions that would not have a material adverse effect on our business,financial condition or results of operations.

 

InJune 2000 and October 2001, we received letters from a competitor inthe outbound call center market claiming that our products utilize technologiespioneered and patented by the competitor. Although our patent counsel has notdetermined the validity of these patents, we have discussed the possiblelicensing of certain technologies from the competitor.  Ownership of the technology has changedtwice since the original letters.  Wecannot assure you that these claims can be resolved amicably withoutlitigation, or that we will be able to enter into licensing arrangements onterms and conditions that would not have a material adverse effect on ourbusiness, financial condition or results of operations.

 

InJuly 2002, we received a letter from a consulting firm which has beenretained by a telecommunication technology provider to develop and implement alicensing program based on the technology provider’s patents. The consultingfirm believes a licensing agreement between us and the technology provider isappropriate. Our patent counsel is in the process of reviewing the patentslisted in the letter. To date, our patent counsel has not determined thevalidity or applicability of these patents. We have also discussed the possiblelicensing of the technology provider’s patents with the consulting firm. Wecannot assure you that this matter can be resolved amicably without litigation,or that we will be able to enter into a licensing arrangement on terms andconditions that would not have a material adverse effect on our business,financial condition or results of operations.

 

InDecember 2002, we received a letter from one of our resellers requestingindemnification related to a request that it had received for indemnificationfrom an end user that had received a letter from a third party indicating thatthe end user may be infringing patents held by the third party. To date, ourpatent counsel has not determined the validity or the applicability of thesepatents as they relate to our products or 

 

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whether the reseller isentitled to indemnification. We cannot assure you that this claim forindemnification can be resolved favorably in a manner that would not have amaterial adverse effect on our business, financial condition or results ofoperations.

 

Otherthird parties have claimed or may in the future claim that our technologyinfringes their proprietary rights. As the number of software products in ourtarget markets increases and the functionality of these products overlap, webelieve that software developers may face infringement claims. For example,various patent rights have been asserted against interfaces between PBXhardware and computer network systems. Although we believe that our products donot infringe any of these patents because, among other reasons, our productsare designed to replace PBXs and not to create such interfaces, if thesepatents were interpreted broadly, claims of infringement of these patents couldhave a material adverse affect on us.

 

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

 

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

 

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

 

Also,in connection with our effort to streamline operations, reduce costs andrationalize our staffing and structure, we had reductions in both 2001 and 2002of our worldwide workforce of approximately 10% -12% each year. There weresubstantial costs associated with the workforce reductions related to severanceand other employee-related costs, and our restructuring plans may still yieldunanticipated consequences, such as attrition beyond our implemented reductionin workforce. As a result, our ability to respond to unexpected challenges maybe impaired and we may be unable to take advantage of new opportunities. Thereduction in workforce may reduce employee morale and may create concern amongexisting employees about job security, which may lead to increased turnover.These reductions in headcount may still subject us to the risk of litigation.In addition, recent trading levels of our common stock have decreased the valueof the stock options granted to employees pursuant to our stock option plans.As a result of these factors, our remaining personnel may seek employment withlarger, more established companies or companies they perceive as having lessvolatile stock prices.

 

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

 

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

 

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

 

•                       Wemay be unable to integrate acquired businesses successfully and realizeanticipated economic, operational and other benefits in a timely manner,particularly if we acquire a 

 

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business in a market inwhich we have limited or no current expertise, or with a corporate culturedifferent from our own. If we are unable to integrate acquired businessessuccessfully, we could incur substantial costs and delays or other operational,technical or financial problems.

 

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

 

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

 

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

 

**OURINTERNATIONAL OPERATIONS INVOLVE FINANCIAL AND OPERATIONAL RISKS**

 

Ourinternational operations require significant management attention and financialresources to establish and operate, including hiring appropriate personnel andrecruiting effective international resellers. Non-North American revenuesaccounted for 15%, 19%, 22%, and 25% of our total revenues  for the six months ended June 30, 2003, andfor the years ended 2002, 2001, and 2000, respectively. To date, our productshave been licensed outside North America primarily in Western Europe, SouthAfrica, and Australia. We also have marketing efforts in Japan, Korea, Chinaand Central and South America. We intend to continue to emphasize ourinternational operations and we may enter additional international markets. Revenuesfrom international operations may be inadequate to cover the expenses of thoseoperations. In addition to foreign currency fluctuation risks described in thenext risk factor, other risks inherent in our international businessactivities, in the countries in which we have licensed our products to date andin those countries in which we operate and could expand into, generally couldinclude the following:

 

•                       economicand political instability;

 

•                       unexpectedchanges in foreign regulatory requirements and laws;

 

•                       tariffsand other trade barriers;

 

•                       timing,cost and potential difficulty of adapting our software products to the locallanguage in those foreign countries that do not use the alphabet that Englishuses, such as Japan, Korea and China;

 

•                       lackof acceptance of our products in foreign countries;

 

•                       longersales cycles and accounts receivable payment cycles;

 

•                       potentiallyadverse tax consequences;

 

•                       restrictionson the repatriation of funds; and

 

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

 

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

 

Ourinternational revenues are generally denominated in U.S. Dollars with theexception of some European resellers and end-user customers located incountries who have adopted the Euro as their official currency. Ourinternational expenses are generally denominated in local foreign currencies.Although foreign currency translation gains and losses have been immaterial todate, fluctuations in exchange rates between the U.S. Dollar and othercurrencies could have a material adverse effect on our business, financialcondition or results of operations, and particularly on our operating margins.To date, we have minimally sought to hedge the risks associated withfluctuations in exchange rates, but we may more actively undertake to do so inthe future. Any hedging techniques we implement in the future may not besuccessful. Exchange rate fluctuations could also make our products moreexpensive than competitive products not subject to these fluctuations, whichcould adversely affect our revenues and profitability in international markets.

** **

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

 

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

 

Ourlicense agreements with our end-user customers typically contain provisions designedto limit our exposure to potential product liability and some contract claims.However, not all of these agreements contain these types of provisions and,where present, these provisions vary as to their terms and may not be effectiveunder the laws of some jurisdictions. A product liability, warranty, or otherclaim brought against us could have a material adverse effect on our business,financial condition or results of operations.

 

Becauseour solution currently consists of our software running on a Windows NT® serverand voice processing boards, it is inherently more prone to performanceinterruptions for our end-user customers than traditional non-software basedproducts. Performance interruptions at our end-user customer sites, most ofwhich currently do not have back-up systems, could affect demand for ourproducts or give rise to claims against us.

 

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

 

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

 

**OURSTOCK PRICE HAS BEEN AND COULD CONTINUE TO BE HIGHLY VOLATILE**

 

Ourstock price has been and could continue to be highly volatile due to a numberof factors, including:

 

•                       actualor anticipated fluctuations in our operating results;

 

•                       announcementsby us, our competitors or our end-user customers;

 

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•                       changesin financial estimates of securities analysts or investors regarding us, ourindustry, our competitors or our end-user customers;

 

•                       technologicalinnovations by others;

 

•                       theoperating and stock price performance of other comparable companies or of ourcompetitors or end-user customers;

 

•                       thelow number of our shares typically traded in any trading session;

 

•                       theavailability for future sale, or sales, of a substantial number of shares ofour common stock in the public market; and

 

•                       generalmarket or economic conditions.

 

Thisrisk may be heightened because our industry is new and evolving, characterizedby rapid technological change and susceptible to the introduction of newcompeting technologies or competitors.

 

Inaddition, the stock market has experienced significant price and volumefluctuations that have particularly affected the trading prices of equitysecurities of many technology companies, including us. These price and volumefluctuations often have been unrelated to the operating performance of theaffected companies. In the past, following periods of volatility in the marketprice of a company’s securities, securities class action litigation has oftenbeen instituted against that company. This type of litigation, regardless ofthe outcome, could result in substantial costs and a diversion of management’sattention and resources, which could materially and adversely affect ourbusiness, financial condition or results of operations.

 

**REGULATORYCHANGES MADE TO GENERALLY ACCEPTED ACCOUNTING PRINCIPLES OR CORPORATE**

**GOVERNANCEMATTERS MAY IMPACT OUR BUSINESS**

 

Revisionsto generally accepted accounting principles will require us to review ouraccounting and financial reporting procedures in order to ensure continuedcompliance with required policies. From time to time, such changes may have ashort-term impact in the reporting that we do, and these changes may impactmarket perception of our financial condition.

 

•                       Pendingor new legislation may lead to an increase in our costs related to audits inparticular and regulatory compliance generally;

 

•                       Pendingor new legislation may force us to seek other service providers fornon-audit-related services, which may raise costs; and

 

•                       Changesin the legal climate may lead to additional liability fears which may result inincreased insurance costs.

 

**WEARE SUBECT TO THE RISK OF TERRORISM, INCLUDING THE RESULTING POSSIBLEDISRUPTIONS IN BUSINESS ACTIVITIES AND LOSS OF BUSINESS**

 

Ourbusiness can be affected by the disruptions caused by terrorist activities.Terrorist acts can create disruptions in our ordinary business activities,including, but not limited to communications, business travel, and the availabilityof key personnel and physical assets. Additionally, terrorist acts may causeuncertainty about business continuity and the effectiveness of our disasterrecovery plans and the disaster recovery plans of our suppliers and resellers,and may adversely affect the confidence and behavior of our customers,employees, suppliers, and resellers.

 

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

 

Therisks and uncertainties discussed above are in addition to those that apply tomost businesses generally. In addition, as we continue to grow our business, wemay encounter other risks of which we are not aware at this time. Theseadditional risks may cause serious damage to our business in the future, theimpact of which we cannot estimate at this time.

 

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

 

We developproducts in the United States and sell licenses in North America, Europe, theAsia/Pacific region, South Africa, and Central and South America. As a result,our financial results could be affected by various factors, including changesin foreign currency exchange rates or weak economic conditions in foreignmarkets. As most sales are currently made in U.S. dollars, a strengthening ofthe dollar could make our products less competitive in foreign markets.  Additionally, as our business matures inforeign markets, we may offer our products and services in certain localcurrencies.  As a result, we will besubject to foreign currency fluctuations which may have an adverse affect onthe company.

 

Wemanage our interest rate risk by maintaining an investment portfolio with debtinstruments of high credit quality and relatively short average maturities. Wealso manage interest rate risk by maintaining sufficient cash and cashequivalent balances such that we are typically able to hold our investments tomaturity.

 

**Item 4****.  Controls and Procedures**

 

     We maintain a set of disclosure controlsand procedures that are designed to ensure that information required to bedisclosed by us in the reports filed by us under the Securities Exchange Act of1934, as amended (“Exchange Act”) is recorded, processed, summarized andreported within the time periods specified in the SEC’s rules and forms.  We carried out an evaluation, under thesupervision and with the participation of our management, including ourPresident and Chief Executive Officer and our Chief Financial Officer andTreasurer, of the effectiveness of the design and operation of our disclosurecontrols and procedures as of June 30, 2003 pursuant to Rule 13a-15(b) of theExchange Act.  Based on that evaluation,our President and Chief Executive Officer and our Chief Financial Officer andTreasurer concluded that our disclosure controls and procedures are effective.

 

     There have been no changes in ourinternal control over financial reporting that occurred during the quarterended June 30, 2003 that has materially affected, or is reasonablylikely to materially affect, our internal control over financial reporting.

 

**P**ART II. OTHER INFORMATION

 

**Item 1. LegalProceedings.**

 

SeeNote 5 of our Notes to the Condensed Consolidated Financial Statements for adescription of various legal issues and contingencies.

 

We arealso subject to ordinary and routine claims, lawsuits and proceedingsincidental to our business, none of which is expected to be material to ourresults of operations, financial condition or cash flows.

 

**Item 4.  Submission of Matters toa Vote of Security Holders**

 

Weheld our annual meeting of shareholders on May 15, 2003.  At that meeting,our shareholders reelected Samuel F. Hulbert, Ph.D. and Randall L.Tobias as Directors of the Company to each serve a three year term and untilhis successor is elected and has qualified.  The final results of thevotes taken at the meeting were as follows:

 

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|                      |   | **Votes  For** |   | **Votes  Withheld** |   | **Broker  Non-Votes** |   | **Abstentions** |
|---------------------------|--------|----------------|--------|---------------------|--------|-----------------------|--------|-----------------|
| Election of Directors     |   |           |   |                |   |                  |   |            |
| Samuel F. Hulbert,  Ph.D. |   | 13,871,976     |   | 553,419             |   | —                |   | —          |
| Randall L. Tobias         |   | 13,871,526     |   | 553,869             |   | —                |   | —          |

 

In addition, thefollowing directors continue in office until the annual meeting of shareholdersin the year indicated:

 
| John R. Gibbs                                              |   | 2004   |
|------------------------------------------------------------|--------|--------|
| (Mr. Gibbs has since  resigned from the Board; see Item 5) |   |   |
| William E. McWhirter                                       |   | 2004   |
| Donald E. Brown, M.D.                                      |   | 2005   |
| Robert A. Compton                                          |   | 2005   |

 

 

**Item 5****.Other Information**

 

EffectiveMay 30, 2003, John R. Gibbs resigned from our Board of Directors, but hecontinues to serve as our Vice President of Corporate Development.

 

**Item 6****. Exhibitsand Reports on Form 8-K.**

 

(a)   Exhibits

 

31.1 Certification of the Chief Executive Officer pursuant to Rule13a-14(a)/15d-14(a) of the Securities Exchange Act of 1934, as adopted pursuantto Section 302 of the Sarbanes-Oxley Act of 2002

 

31.2 Certification of the Chief Financial Officer pursuant to Rule13a-14(a)/15d-14(a) of the Securities Exchange Act of 1934, as adopted pursuantto Section 302 of the Sarbanes-Oxley Act of 2002

 

32.1 Certification ofDonald E. Brown, M.D., CEO, pursuant to 18 U.S. C. Section 1350, as adoptedpursuant to Section 906 of the Sarbanes-Oxley Act of 2002

 

32.2 Certification ofKeith A. Midkiff, CFO, pursuant to 18 U.S. C. Section 1350, as adopted pursuantto Section 906 of the Sarbanes-Oxley Act of 2002

 

(b)   Reports on Form 8-K

 

1.  On April22, 2003, the Company furnished, not filed, a Form 8-K attaching a pressrelease describing its results of operations for the quarter ended March 31,2003.

 

2.  On May 30,2003, the Company filed a Form 8-K announcing that the Company had dismissedErnst & Young LLP as the Company’s independent public accountants and thatthe Company had retained KPMG LLP as such independent public accountants.

 

3.  On June 13,2003, the Company filed a Form 8-K announcing that Ernst & Young LLP hadbeen dismissed as the independent auditors for the Interactive Intelligence,Inc. 401(k) Savings Plan and that KPMG LLP had been retained as suchindependent auditors.

 

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**SIGNATURES**

 

Pursuant to therequirements of the Securities Exchange Act of 1934, the Registrant has dulycaused this report to be signed on its behalf by the undersigned thereunto dulyauthorized.

 
|                  |   | Interactive  Intelligence, Inc.                                                                                   |
|-----------------------|--------|-------------------------------------------------------------------------------------------------------------------|
|                  |   | (Registrant)                                                                                                      |
|                  |   |                                                                                                              |
| Date: August 14, 2003 |   | By  /s/ Keith A. Midkiff                                                                                     |   |
|                  |   |                                                                                                              |
|                  |   | Keith A. Midkiff                                                                                                  |
|                  |   | Chief Financial  Officer, Secretary and Treasurer  (Principal Financial Officer and Principal Accounting Officer) |

 

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