** **

**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

 

**Washington,D.C. 20549**

 

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**FORM 10-Q**

 

**(MarkOne)**

 

**ý****       ****QUARTERLY REPORTPURSUANT TO SECTION 13OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

 

**Forthe quarterly period ended September 30, 2003**

 

**Or**

 

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

 

**For the transition periodfrom                 to                 **

 

**Commission File Number 000-27385**

 

**INTERACTIVEINTELLIGENCE, INC.**

(Exact name of registrant asspecified 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 checkmark whether the registrant (1) has filed all reportsrequired to be filed by Section 13 or 15(d) of the Securities Exchange Actof 1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject to suchfiling requirements for the past 90 days.

 

Yes  ý   No  o

 

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

 

The number of shares of common stock outstanding on October 31,2003 was 15,693,097.

 

 

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TABLE OF CONTENTS

 
| PART I. FINANCIAL INFORMATION |
|-------------------------------|
|                          |   |
| Item 1.                       | Condensed Consolidated Balance Sheets as of  September 30, 2003 (unaudited) and December 31, 2002 |
|                          |   |
|                          | Condensed  Consolidated Statements of Operations for the three and nine months ended  September 30, 2003 and 2002 (unaudited) |
|                          |   |
|                          | Condensed  Consolidated Statements of Cash Flows for the nine months ended  September 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 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 Statements and Footnotes.**

 

**Interactive Intelligence, Inc.**

 

**Condensed Consolidated Balance Sheets**

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

 
|                                                                                                                    |   | **September 30,  2003** |   | **December 31,  2002** |   |
|-------------------------------------------------------------------------------------------------------------------------|--------|------------------------------|--------|-----------------------------|--------|
|                                                                                                                    |   | **(Unaudited)**              |   |                        |   |
| **Assets**                                                                                                              |   |                         |   |                        |   |
| Current  assets:                                                                                                        |   |                         |   |                        |   |
| Cash and  cash equivalents                                                                                              |   | $                            | 12,084 |                        | $      | 5,913 |   |
| Short-term  investments                                                                                                 |   | 3,010                        |   | 9,331                       |   |
| Accounts  receivable, net of allowance for doubtful accounts of $297 in 2003 and $671  in 2002                          |   | 7,151                        |   | 9,047                       |   |
| Prepaid  expenses                                                                                                       |   | 1,464                        |   | 2,170                       |   |
| Other  current assets                                                                                                   |   | 241                          |   | 73                          |   |
| Total  current assets                                                                                                   |   | 23,950                       |   | 26,534                      |   |
|                                                                                                                    |   |                         |   |                        |   |
| Property  and equipment, net                                                                                            |   | 6,300                        |   | 7,586                       |   |
| Other  assets, net                                                                                                      |   | 725                          |   | 1,046                       |   |
| Total  assets                                                                                                           |   | $                            | 30,975 |                        | $      | 35,166 |   |
|                                                                                                                    |   |                         |   |                        |   |
| **Liabilities and shareholders’ equity**                                                                           |   |                         |   |                        |   |
| Current  liabilities:                                                                                                   |   |                         |   |                        |   |
| Accounts  payable and accrued liabilities                                                                               |   | $                            | 4,653  |                        | $      | 3,203 |   |
| Accrued  compensation and related expenses                                                                              |   | 886                          |   | 995                         |   |
| Deferred  software revenues                                                                                             |   | 9,078                        |   | 12,102                      |   |
| Deferred  services revenues                                                                                             |   | 11,561                       |   | 9,882                       |   |
| Total  current liabilities                                                                                              |   | 26,178                       |   | 26,182                      |   |
|                                                                                                                    |   |                         |   |                        |   |
| Shareholders’  equity:                                                                                             |   |                         |   |                        |   |
| Preferred  stock,  no par value; 10,000,000  shares authorized;  no shares issued and outstanding                  |   | —                       |   | —                      |   |
| Common  stock, $0.01 par value; 100,000,000 shares authorized;  15,655,733 and 15,524,369 shares issued and outstanding |   | 156                          |   | 155                         |   |
| Additional  paid-in capital                                                                                             |   | 64,488                       |   | 64,140                      |   |
| Accumulated  other comprehensive income                                                                                 |   | 251                          |   | 162                         |   |
| Accumulated  deficit                                                                                                    |   | (60,098                      | )      | (55,473                     | )      |
| Total  shareholders’ equity                                                                                        |   | 4,797                        |   | 8,984                       |   |
| Total  liabilities and shareholders’ equity                                                                        |   | $                            | 30,975 |                        | $      | 35,166 |   |

 

See accompanying notes to condensedconsolidated financial statements.

 

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**Interactive Intelligence, Inc.**

 

**CondensedConsolidated Statements of Ope****rations (unaudited)**

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

 
|                                        |   | **Three  months ended  September 30,** |       | **Nine  months ended  September 30,** |       |
|---------------------------------------------|--------|---------------------------------------------|------------|--------------------------------------------|------------|
|                                        |   | **2003**                                    |       | **2002**                                   |       | **2003** |   | **2002** |   |
|                                        |   |                                        | ** ** |                                       | ** ** |   | ** ** |   | ** ** |
| Revenues:                                   |   |                                        |       |                                       |       |   |   |   |   |
| Software                                    |   | $                                           | 5,684      |                                       | $          | 6,753 |   | $ | 20,077 |   | $ | 22,049 |   |
| Services                                    |   | 6,455                                       |       | 5,147                                      |       | 18,553 |   | 13,924 |   |
| Total  revenues                             |   | 12,139                                      |       | 11,900                                     |       | 38,630 |   | 35,973 |   |
|                                        |   |                                        |       |                                       |       |   |   |   |   |
| Costs and  expenses:                        |   |                                        |       |                                       |       |   |   |   |   |
| Costs of  software                          |   | 254                                         |       | 273                                        |       | 871 |   | 737 |   |
| Costs of  services                          |   | 2,962                                       |       | 2,920                                      |       | 9,402 |   | 8,808 |   |
| Sales and  marketing                        |   | 5,028                                       |       | 5,189                                      |       | 15,145 |   | 15,929 |   |
| Research  and development                   |   | 3,322                                       |       | 3,739                                      |       | 10,289 |   | 11,357 |   |
| General  and administrative                 |   | 1,546                                       |       | 1,369                                      |       | 4,358 |   | 4,247 |   |
| Restructuring  charges                      |   | 34                                          |       | —                                     |       | 3,172 |   | 682 |   |
| Total  costs and expenses                   |   | 13,146                                      |       | 13,490                                     |       | 43,237 |   | 41,760 |   |
| Operating  loss                             |   | (1,007                                      | )          | (1,590                                     | )          | (4,607 | ) | (5,787 | ) |
|                                        |   |                                        |       |                                       |       |   |   |   |   |
| Interest  income, net                       |   | 36                                          |       | 86                                         |       | 132 |   | 319 |   |
| Loss  before income taxes                   |   | (971                                        | )          | (1,504                                     | )          | (4,475 | ) | (5,468 | ) |
|                                        |   |                                        |       |                                       |       |   |   |   |   |
| Income  taxes                               |   | 54                                          |       | 50                                         |       | 150 |   | 179 |   |
| Net loss                                    |   | $                                           | (1,025     | )                                          | $          | (1,554 | ) | $ | (4,625 | ) | $ | (5,647 | ) |
|                                        |   |                                        | ** ** |                                       | ** ** |   | ** ** |   | ** ** |
| Net loss  per share:                        |   |                                        | ** ** |                                       | ** ** |   | ** ** |   | ** ** |
| Basic and  diluted                          |   | $                                           | (0.07      | )                                          | $          | (0.10 | ) | $ | (0.30 | ) | $ | (0.37 | ) |
|                                        |   |                                        |       |                                       |       |   |   |   |   |
| Shares  used to compute net loss per share: |   |                                        |       |                                       |       |   |   |   |   |
| Basic and  diluted                          |   | 15,638                                      |       | 15,453                                     |       | 15,601 |   | 15,396 |   |

 

See accompanying notes to condensedconsolidated financial statements.

 

4

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**Interactive Intelligence, Inc.**

 

**CondensedConsolidated Statements of Cas****h Flows (unaudited)**

**(in thousands)**

 
|                                                                                    |   | **Nine  months ended  September 30,** |   |
|-----------------------------------------------------------------------------------------|--------|--------------------------------------------|--------|
|                                                                                    |   | **2003**                                   |   | **2002** |   |
| **Operating activities**                                                                |   |                                       |   |   |   |
| Net loss                                                                                |   | $                                          | (4,625 | ) | $ | (5,647 | ) |
| Adjustments  to reconcile net loss to net cash provided (used) by operating activities: |   |                                       |   |   |   |
| Depreciation                                                                            |   | 3,464                                      |   | 3,907 |   |
| Amortization  of deferred stock-based compensation                                      |   | 79                                         |   | 89 |   |
| Loss on  disposal of fixed assets                                                       |   | 539                                        |   | — |   |
| Changes  in operating assets and liabilities:                                           |   |                                       |   |   |   |
| Accounts  receivable                                                                    |   | 1,896                                      |   | 1,018 |   |
| Prepaid  expenses                                                                       |   | 706                                        |   | 336 |   |
| Other  current assets                                                                   |   | (168                                       | )      | 133 |   |
| Accounts  payable and accrued liabilities                                               |   | 1,450                                      |   | (37 | ) |
| Accrued  compensation and related expenses                                              |   | (109                                       | )      | (169 | ) |
| Deferred  software revenues                                                             |   | (3,024                                     | )      | (2,286 | ) |
| Deferred  services revenues                                                             |   | 1,679                                      |   | (66 | ) |
| Net cash  provided (used) by operating activities                                       |   | 1,887                                      |   | (2,722 | ) |
|                                                                                    |   |                                       |   |   |   |
| **Investing activities**                                                                |   |                                       |   |   |   |
| Purchases  of property and equipment, net                                               |   | (2,717                                     | )      | (2,541 | ) |
| Purchases  of available-for-sale investments                                            |   | —                                     |   | (15,026 | ) |
| Sales of  available-for-sale investments                                                |   | 6,410                                      |   | 10,960 |   |
| Change in  other assets                                                                 |   | 321                                        |   | 6 |   |
| Net cash  provided (used) by investing activities                                       |   | 4,014                                      |   | (6,601 | ) |
|                                                                                    |   |                                       |   |   |   |
| **Financing activities**                                                                |   |                                       |   |   |   |
| Proceeds  from issuances of common stock                                                |   | 245                                        |   | 338 |   |
| Proceeds  from stock options exercised                                                  |   | 25                                         |   | 109 |   |
| Net cash  provided by financing activities                                              |   | 270                                        |   | 447 |   |
| Net  increase (decrease) in cash and cash equivalents                                   |   | 6,171                                      |   | (8,876 | ) |
|                                                                                    |   |                                       |   |   |   |
| Cash and  cash equivalents, beginning of period                                         |   | 5,913                                      |   | 14,503 |   |
| Cash and  cash equivalents, end of period                                               |   | $                                          | 12,084 |   | $ | 5,627 |   |

 

See accompanying notes to condensedconsolidated financial statements.

 

5

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Interactive Intelligence, Inc.Notes to Condensed ConsolidatedFinancial 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 andExchange Commission.  In our opinion,the statements include all adjustments necessary (which are of a normal andrecurring nature) for the fair presentation of the results of the interimperiods presented.

 

The balance sheet at December 31, 2002 has been derived from theaudited financial statements at that date but does not include all of theinformation and footnotes required by generally accepted accounting principlesfor complete financial statements.

 

These financial statements should be read in conjunction with ouraudited consolidated financial statements for the year ended December 31,2002, included in the Company’s Form 10-K for the year ended December 31,2002, filed with the Securities and Exchange Commission on March 31,2003.  Our results of operations for anyinterim period are not necessarily indicative of the results of operations forany other interim period or for a full fiscal year.

 

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

 

Basic net loss per share is calculated based on the weighted-averagenumber of outstanding common shares. Diluted net loss per share is calculated based on the weighted-averagenumber of outstanding common shares plus the effect of dilutive potentialcommon shares.

 

6

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

 
|                                                 |   | **Three  months ended  September 30,** |   | **Nine  months ended  September 30,** |   |
|------------------------------------------------------|--------|----------------------------------------|--------|---------------------------------------|--------|
|                                                 |   | **2003**                               |   | **2002**                              |   | **2003** |   | **2002** |   |
| Net loss                                             |   | $                                      | (1,025 | )                                     | $      | (1,554 | ) | $ | (4,625 | ) | $ | (5,647 | ) |
|                                                 |   |                                   |   |                                  |   |   |   |   |   |
| Basic and diluted:                                   |   |                                   |   |                                  |   |   |   |   |   |
| Weighted average  outstanding shares of common stock |   | 15,638                                 |   | 15,453                                |   | 15,601 |   | 15,396 |   |
|                                                 |   |                                   |   |                                  |   |   |   |   |   |
| Basic and diluted net loss  per common share         |   | $                                      | (0.07  | )                                     | $      | (0.10 | ) | $ | (0.30 | ) | $ | (0.37 | ) |

 

The Company’s calculation of diluted net loss per share excludes allpotential common shares as the effect would be antidilutive.  Options to purchase 3,528,044 shares ofcommon stock with exercise prices of $0.13 to $50.50 per share were outstandingas of September 30, 2003 and options to purchase 3,312,608 shares ofcommon stock with exercise prices of $0.13 to $50.50 per share were outstandingas of September 30, 2002.

 

**3.****              Stock-BasedCompensation**

 

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 to Employees,*and related Interpretations.  Themajority of options granted to employees under these plans had an exerciseprice equal to the market value of the underlying common stock on the date ofgrant.  The table included belowillustrates the effect on the net loss and loss per share if the Company hadapplied the fair value recognition provisions of SFAS 123 to stock-basedemployee compensation. (*in thousands exceptper share amounts):*

 
|                                                                                                                                 |   | **Three  months ended  September 30,** |   | **Nine  months ended  September 30,** |   |
|--------------------------------------------------------------------------------------------------------------------------------------|--------|----------------------------------------|--------|---------------------------------------|--------|
|                                                                                                                                 |   | **2003**                               |   | **2002**                              |   | **2003** |   | **2002** |   |
| Net loss, as reported                                                                                                                |   | $                                      | (1,025 | )                                     | $      | (1,554 | ) | $ | (4,625 | ) | $ | (5,647 | )  |
| Deduct: Total stock-based  compensation expense determined under fair value based method for all awards,  net of related tax effects |   | (1,287                                 | )      | (1,419                                | )      | (4,057 | ) | (4,225 | ) |
| Pro forma net loss                                                                                                                   |   | $                                      | (2,312 | )                                     | $      | (2,973 | ) | $ | (8,682 | ) | $ | (9,872 | )  |
|                                                                                                                                 |   |                                   |   |                                  |   |   |   |   |   |
| Loss per share:                                                                                                                      |   |                                   |   |                                  |   |   |   |   |   |
| Basic and diluted - as  reported                                                                                                     |   | $                                      | (0.07  | )                                     | $      | (0.10 | ) | $ | (0.30 | ) | $ | (0.37 | )  |
| Basic and diluted - pro  forma                                                                                                       |   | $                                      | (0.15  | )                                     | $      | (0.19 | ) | $ | (0.56 | ) | $ | (0.64 | )  |
|                                                                                                                                      |        |                                        |        |                                       |        |  |  |  |  |  |  |  |  |  |

 

 

7

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**4.     Contingencies**

 

Since 1999, the Companyhas received a number of claims from competitors and other technology providersclaiming that the Company’s products do or may utilize their proprietarytechnologies.  One such claim hasresulted in a legal proceeding being filed against the Company.  (See Part II. Other Information, Item 1.Legal Proceedings).  The Company cannotassure you that these matters can be resolved amicably without litigation, orthat it will be able to enter into licensing arrangements on terms andconditions that would not have a material adverse effect on the Company'sbusiness, financial condition or results of operations.

 

In December 2002,the Company received a letter from one of its resellers requestingindemnification related to a request that the reseller had received forindemnification from an end user.  Theend user had received a letter from a third party indicating that the end usermay be infringing patents held by the third party.  To date, the Company’s patent counsel has not determined thevalidity or the applicability of these patents as they relate to the Company’sproducts or whether the reseller is entitled to indemnification.  The Company cannot assure you that thisclaim for indemnification can be resolved favorably in a manner that would nothave a material adverse effect on the Company’s business, financial conditionor results of operations. 

 

In November 2002,the Company received a notification from the French government as a result of atax audit 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 $2.7 million as ofSeptember 30, 2003 and the

 

8

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assessment related tocorporation taxes is approximately 300,000 Euros or approximately $350,000 asof September 30, 2003.  Basedprimarily on advice from the Company’s France-based tax counsel, the Companycurrently believes the possibility of the Company paying the assessment relatedto VAT to be remote and the assessment related to corporation taxes to bereasonably possible.  The Company isappealing the assessment, but cannot assure you this matter will be resolvedwithout litigation, that it will not take several years to resolve, or that theCompany will not have to pay some or all of the assessment. 

 

The Company is alsosubject to various legal proceedings and claims that arise in the normal courseof business. While the outcome of these proceedings and claims cannot bepredicted with certainty, management does not believe that the outcome of anyof these legal matters will have a material adverse effect on the Company’sbusiness, operating results or financial condition.  Litigation in general, and intellectual property litigation in particular,can be expensive and disruptive to normal business operations.  Moreover, the results of complex legalproceedings are difficult to predict.

 

The Company has notaccrued any expense for these contingencies because it believes that a loss isnot probable and/or estimable in accordance with SFAS 5, *Accounting for Contingencies.*

 

**5.****              Restructuring andOther Charges**

 

In February 2003,the Company announced its plan to downsize and reorganize resources in Europe,the Middle East, and the African (“EMEA”) region.  The French office was significantly affected.  Of the 20 positions located in France, sevenpositions were transferred to other EMEA offices, eight positions have beeneliminated, two positions remain to be eliminated and three positions remain inFrance.  The Company determined that theseverance payments and related legal fees qualified as restructuring costs inaccordance with Statement of Financial Accounting Standards (“SFAS”) No. 146, *Accounting for Costs Associated with Exit or DisposalActivities.*

 

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, qualifiedas an exit cost and was recognized in accordance with SFAS 146 as restructuringcharges.

 

The Company recognizedrestructuring charges in accordance with SFAS 146 of $34,000 and $3.2 millionfor the three and nine months ended September 30, 2003, respectively.  The Company incurred expenses of approximately$89,000 and $1.0 million for the three and nine months ended September 30,2003, respectively related to severance. Other expenses included additional EMEA restructuring costs, offset bythe positive impact of a sub-lease obtained during the third quarter.

 

The Company anticipatesadditional restructuring charges in the range of approximately $200,000 to$250,000 will be incurred related to the termination of two employees in Franceand additional professional fees related to the EMEA reorganization.  The Company does not anticipate anyadditional restructuring charges related to the relocation of its world-wideheadquarters.

 

A summary of thebeginning accrued restructuring charges, expensed amount, cash payments and theending accrued restructuring charges for the nine months endedSeptember 30, 2003 is presented below (in thousands).

 

9

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|                                    |   | **EMEA  Restructuring  Operations** |   | **Headquarters  Relocation** |   | **Total** |   |
|-----------------------------------------|--------|-------------------------------------|--------|------------------------------|--------|-----------|--------|
|                                    |   |                                |   |                         |   |      |   |
| Beginning balance at  December 31, 2002 |   | $                                   | — |                         | $      | —    |   | $ | — |   |
| Expensed  amount                        |   | 1,502                               |   | 1,670                        |   | $         | 3,172  |   |
| Payments                                |   | (944                                | )      | (1,018                       | )      | $         | (1,962 | ) |
| Ending balance at September  30, 2003   |   | $                                   | 558    |                         | $      | 652       |   | $ | 1,210 |   |

 

**6.****              Recent AccountingPronouncements**

 

In April 2003, the Financial Accounting Standards Board (“FASB”)issued SFAS No. 149, *Amendment of Statement133 on Derivative Instruments and Hedging Activities*.  SFAS No. 149 amends and clarifies accountingfor derivative instruments, including certain derivative instruments embeddedin other contracts, and for hedging activities under SFAS No. 133, *Accounting for Derivative Instruments and HedgingActivities*.  In particular,SFAS No. 149 clarifies under what circumstances a contract with an initial netinvestment meets the characteristics of a derivative and when a derivative containsa financing component that warrants special reporting in the statement of cashflows.  SFAS No. 149 is generallyeffective for contracts entered into or modified after June 30, 2003 andis not expected to have a material impact on the Company’s financial positionor results of operations.

 

In May 2003, the FASB issued SFAS No. 150, *Accounting for Certain Financial Instruments withCharacteristics 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 afterMay 31, 2003, and otherwise is effective at the beginning of the firstinterim period beginning after June 15, 2003.  Adoption of this Statement did not have a significant impact onthe Company’s financial position or results of operations.

 

**Item2.  Management’s Discussion and Analysisof Financial Condition and Results of 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-looking statements can be identified by their use of such verbs as“expects,” “anticipates,” and “believes” or similar verbs or conjugations ofsuch verbs. If any of our assumptions on which the statements are based proveincorrect or should unanticipated circumstances arise, our actual results couldmaterially differ from those anticipated by such forward-looking statements.The differences could be caused by a number of factors or combination offactors, including, but not limited to, the “Factors Affecting OperatingResults” described herein and the Risk Factors described in our Securities andExchange Commission filings, including the Form 10-K filing for the yearended December 31, 2002.

 

*Overview*

 

Wecommenced operations in October 1994. Through the end of 1996, we focusedprimarily on research and development activities. Our first product wasreleased in March 1997. In 1997 and 1998, we expanded our operations tocapitalize on the increased market demand for communications and interactionmanagement software. We decided, at the expense of profitability, to continueinvesting significantly in research and development, and to accelerate ourinvestments in marketing, services and sales operations. We had no revenue in1996, and our total revenues were $1.6 million in 1997, $9.0 millionin 1998, $19.1 million in 1999, $27.3 million in 2000,$47.9 million in 2001, $47.8 million in 2002 and $38.6 

 

10

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million for the ninemonths ended September 30, 2003. We cannot assure you that our revenueswill 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 contributed to the net losses andoperating losses that we have incurred in nearly all quarters since ourformation. In addition, we may experience losses and negative cash flows fromoperations in future quarters. We cannot assure you when or if we will achieveprofitability again or, if achieved, that we will be able to sustainprofitability. Our operating results have varied significantly from quarter toquarter and may continue to do so in the future. As a result, we believe thatperiod-to-period comparisons of our operating results are not necessarilymeaningful, and you should not rely on them as an indication of our futureperformance.

 

Forthe nine months ended September 30, 2003 we incurred approximately $3.2million in charges related to the restructuring of our European operations andrelocation of our worldwide headquarters. These charges related primarily to severance, professional services andongoing lease obligations.

 

*CriticalAccounting Policies and Estimates*

 

Webelieve the accounting policies that are related to revenue recognition and theallowance for doubtful accounts receivable are important to understanding ourperformance. These policies, which involve significant management judgment andestimates, and related procedures are described in detail below.

 

**Sourcesof Revenues and Revenue Recognition Policy**

 

TheCompany generates software revenues from licensing the right to use itssoftware products and generates services revenues from annual renewal fees,annual maintenance fees, educational services, and professional services.

 

Oursoftware license fees primarily originate from the marketing efforts of our resellers,who are authorized to place orders for software licenses with us on behalf ofend-user customers. We share end-user customer software license fees with theseresellers in varying percentages of our list price, according to the terms oftheir reseller agreements. In addition to generating software license feesindirectly through resellers, we also receive some software license fees fromend-user customers that we contract with directly. Our software licenseagreements are either annually renewable or perpetual.

 

Forany revenues to be recognized from a software license agreement, the followingcriteria must be met:

 

•                  persuasiveevidence of an arrangement exists;

 

•                  the fee is fixedor determinable;

 

•                  collection isprobable; and

 

•                  delivery has occurred.

 

Deliveryis further defined in certain software license agreements as delivery of theproduct master or first copy for non-cancelable product licensing arrangementsunder which the recipient, typically a reseller, has certain softwaredistribution rights. For these licensing arrangements, the delivery criteriahave been met when a binding order for a specified end-user customer is placed,as the reseller already possesses a product master copy and the Company has nofurther delivery obligations.

 

Underour annually renewable license agreements, the reseller order or end-usercontract includes:

 

1) an initial license fee and

 

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2) an annual renewal fee.

 

Uponmeeting the revenue recognition criteria, we recognize a portion of the initiallicense fees under these annually renewable license agreements as softwarerevenues ratably over the initial license period, which is generally twelvemonths.

 

Underour annually renewable license agreements, we also recognize annual renewalfees as services revenues ratably over the initial license period, which isgenerally twelve months.  The allocationof the initial order between software revenues (initial license fees) and servicesrevenues (annual renewal fees) is based on actual renewal fee rates.  After the initial license period, ourend-user customers may renew their license agreement for an additional annualperiod by paying an additional annual renewal fee. If the annual renewal fee isnot paid, the customer is no longer entitled to use the software and we mayterminate its license agreement. Payment of the annual renewal fee alsoentitles the customer to post-contract technical support and unspecifiedproduct upgrades for the renewal period. We recognize these additional annual renewal fees as services revenuesratably over the term of the renewal period, which is also generally twelvemonths.

 

Underour perpetual license agreements, the reseller order or end-user contractincludes:

 

1) aninitial license fee, and

2) anannual maintenance fee.

 

Uponmeeting the revenue recognition criteria, we immediately recognize the entireamount of initial license fees under these perpetual license agreements assoftware revenues if sufficient vendor specific objective evidence exists tosupport allocating a portion of the total fee to the undelivered elements ofthe arrangement. If sufficient vendor specific objective evidence of theundelivered elements does not exist, we typically recognize the initial licensefee ratably over the initial term, which is generally twelve months.

 

Underour perpetual license agreements, we also recognize annual maintenance fees asservices revenues ratably over the post-contract maintenance period, which istypically twelve months. Our end-user customers may renew their maintenanceterm for an additional one-year period by paying an additional maintenance fee.Payment of the annual maintenance fee entitles the customer to post-contracttechnical support and unspecified product upgrades. We recognize theseadditional maintenance fees as services revenues ratably over the term of therenewal period, which is also generally twelve months.

 

Weshare annual renewal fees and annual maintenance fees with those resellers whoprovide initial technical support to end-user customers according to the termsof their reseller agreements. When these revenues are shared with resellers, wetypically receive between 50% and 70% of the amount charged by the reseller tothe end-user customer.  We recognizethese annual renewal fees and annual maintenance fees as services revenuesratably over the term of the renewal period, which is generally twelve months.

 

Wealso generate revenues from other services that we provide to our resellers andend-user customers. In addition to annual renewal fees and annual maintenancefees, services revenues include fees for educational services and professionalservices. Revenues from educational services, which consist of training coursesfor resellers and end-user customers, and professional services, which includeimplementing and customizing our products for an end-user customer, aretypically recognized as the related services are performed.

 

**Allowancefor Doubtful Accounts Receivable**

 

Werecord our allowance for doubtful accounts for each reporting period based on adetailed analysis of our accounts receivable at the end of that period. Inestimating the allowance for doubtful accounts, we primarily consider the ageof the reseller’s or customer’s accounts receivable and also consider thecreditworthiness of the reseller or customer, the economic conditions of thecustomer’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.

 

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Specifically, if thefinancial condition of our customers were to deteriorate, affecting theirability to make payments, increases to allowances for doubtful accounts may berequired.

 

*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 nine months endedSeptember 30, 2003 and 2002 are not necessarily indicative of the resultsthat may be expected for the full year or for any future period.

 
|                       |   | **Three  months ended  September 30,** |   | **Nine  months ended  September 30,** |   |
|----------------------------|--------|----------------------------------------|--------|---------------------------------------|--------|
|                       |   | **2003**                               |   | **2002**                              |   | **2003** |   | **2002** |   |
|                       |   |                                   |   |                                  |   |   |   |   |   |
| Revenues:                  |   |                                   |   |                                  |   |   |   |   |   |
| Software                   |   | 47                                     | %      | 57                                    | %      | 52 | % | 61 | % |
| Services                   |   | 53                                     |   | 43                                    |   | 48 |   | 39 |   |
| Total revenues             |   | 100                                    |   | 100                                   |   | 100 |   | 100 |   |
|                       |   |                                   |   |                                  |   |   |   |   |   |
| Costs and expenses:        |   |                                   |   |                                  |   |   |   |   |   |
| Costs of software          |   | 2                                      |   | 2                                     |   | 2 |   | 2 |   |
| Costs of services          |   | 25                                     |   | 25                                    |   | 25 |   | 24 |   |
| Sales and marketing        |   | 41                                     |   | 44                                    |   | 39 |   | 44 |   |
| Research and development   |   | 27                                     |   | 31                                    |   | 27 |   | 32 |   |
| General and administrative |   | 13                                     |   | 12                                    |   | 11 |   | 12 |   |
| Restructuring charges      |   | —                                 |   | —                                |   | 8 |   | 2 |   |
| Total costs and expenses   |   | 108                                    |   | 114                                   |   | 112 |   | 116 |   |
|                       |   |                                   |   |                                  |   |   |   |   |   |
| Operating loss             |   | (8                                     | )      | (14                                   | )      | (12 | ) | (16 | ) |
| Interest income, net       |   | —                                 |   | 1                                     |   | — |   | 1 |   |
| Loss before income taxes   |   | (8                                     | )      | (13                                   | )      | (12 | ) | (15 | ) |
| Income taxes               |   | —                                 |   | —                                |   | — |   | — |   |
| Net loss                   |   | (8                                     | )%     | (13                                   | )%     | (12 | )% | (15 | )% |

 

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*Revenues*

 

Ourtotal revenues increased 2% from $11.9 million for the three months endedSeptember 30, 2002, to $12.1 million for the three months endedSeptember 30, 2003.  Total revenuesincreased 7% from $36.0 million for the nine months ended September 30,2002, to $38.6 million for the nine months ended September 30, 2003.  Non-North American revenues decreased from$2.0 million for the three months ended September 30, 2002, to $1.7million at September 30, 2003 and decreased from $6.2 million to $5.7million for the nine months ended September 30, 2002 andSeptember 30, 2003, respectively. Our revenues are derived from software license fees and charges forservices, including annual renewal fees, annual maintenance fees, educationservices, and professional services. The relative amount of services revenuesin the 2003 periods increased compared to the 2002 periods primarily as aresult of increased annual license fees and annual maintenance fees from ourgrowing customer base.  The increase intotal revenues for the three and nine month periods in 2003 compared to 2002resulted from these higher services revenues being partially offset by slightlylower software revenues.

 

*Software.*  Our software revenuesdecreased 16% from $6.8 million for the three months endedSeptember 30, 2002, to $5.7 million for the three months endedSeptember 30, 2003. Software revenues decreased 9% from $22.0 million forthe nine months ended September 30, 2002, to $20.1 million for the ninemonths ended September 30, 2003. We believe the decrease in software revenues resulted from a weakcapital spending environment, causing many of our customers and prospectivecustomers to delay and/or reduce their capital spending and relatedprofessional services.  We expect thechallenging sales environment for capital spending to continue.  Factors that could impact our softwarerevenues and deferred software revenues in the remainder of 2003 compared to2002 include whether we can increase the amount of our enterprise productlicenses (e.g., CommunitéTM and Enterprise Interaction Center®), the license mixof perpetual licenses compared to annually renewable licenses, and seasonality,which is typically weighted toward the end of a calendar year.

 

*Services.*  Services revenuesincreased 25% from $5.1 million for the three months endedSeptember 30, 2002, to $6.5 million for the three months endedSeptember 30, 2003. Services revenues increased 33% from $13.9 million forthe nine months ended September 30, 2002, to $18.6 million for the ninemonths ended September 30, 2003. The increase in services revenues from both 2002 periods to 2003 periodswas primarily due to an increase in annual renewal fees and annual maintenancefees, both of which are related to our growing installed base of end-usercustomers.  As we add more customers andfocus on servicing our existing customer base, we may be able to continue togrow our services revenues.

 

*Costand Expenses*

 

Ourtotal costs and expenses decreased 3% from $13.5 million for the threemonths ended September 30, 2002 to $13.1 million for the three monthsended September 30, 2003.  Thisdecrease is primarily attributable to slight decreases in sales and marketing,and research and development expenses. Total costs and expenses increased 4% from $41.8 million for the ninemonths ended September 30, 2002 to $43.2 million for the nine months endedSeptember 30, 2003.  This increasewas related to restructuring charges in 2003, which were partially offset bylower sales and marketing expenses and lower research and development expenses.

 

*Costs of Software.*  Costs ofsoftware consist primarily of product royalties paid to third-parties for theuse of their technologies in our products and, to a lesser extent, softwarepackaging costs, which include product media, duplication and documentation.Costs of software decreased from $273,000 for the three months endedSeptember 30, 2002 to $254,000 for the three months endedSeptember 30, 2003.  Costs ofsoftware increased from $737,000 for the nine months ended September 30,2002, to $871,000 for the nine months ended September 30, 2003.  Cost of software represented approximately4% of software revenues for both the three months ended September 30, 2002and September 30, 2003, and 3% and 4% for the nine months endedSeptember 30, 2002 and September 30, 2003, respectively. The dollarincrease for the nine months ended September 30, 2003 was primarilyattributable to product royalties for specific functionality included insoftware revenues recognized during the period.  While costs of software tend to move in the same direction as theincrease or decrease in 

 

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overall softwarerevenues, the amount is also affected by royalties for specific functionalityincluded in software contracts.

 

*Costs of Services.*  Costs ofservices 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 September 30, 2002, to$3.0 million for the three months ended September 30, 2003.  Costs of services increased from $8.8million for the nine months ended September 30, 2002, to $9.4 million forthe nine months ended September 30, 2003. As a percentage of services revenues, cost of services represented 57%and 46% for the three months ended September 30, 2002 and 2003,respectively, and 63% and 51% for the nine months ended September 30, 2002and September 30, 2003, respectively. The dollar increase was primarily a result of increased servicesrevenues, including costs to support the growing customer base.  The decrease of cost of services as apercentage of services revenues was related to continued operating efficienciesbeing realized by our services resources as our customer base grows.  While we anticipate that costs of servicesmay increase as we add more customers and service our existing customer base,we also believe there is an opportunity for costs of services to slightlydecline as a percentage of services revenues.

 

*Sales and Marketing.*  Sales andmarketing expenses primarily consist of compensation expenses (including salescommissions), travel expenses, trade shows, telemarketing campaigns, publicrelations and other promotional expenses. Sales and marketing expenses decreased from $5.2 million for thethree months ended September 30, 2002 to $5.0 million for the three monthsended September 30, 2003.  Thisdecrease was primarily the result of reduced sales commissions associated withlower software revenues.  Sales andmarketing expenses decreased from $15.9 million for the nine months endedSeptember 30, 2002, to $15.1 million for the nine months endedSeptember 30, 2003.  This decreasewas primarily the result of reduced compensation and discretionary marketingexpenditures following the implementation of our 2002 restructuring plans, andsomewhat reduced sales commissions associated with lower softwarerevenues.  We plan to increase sales andmarketing efforts if performance dictates and/or attractive opportunitiespresent themselves in the future.

 

*Research and Development.*  Researchand development expenses consist primarily of compensation and related expensesfor our developers and, to a lesser extent, third party efforts to develop newproducts and enhance existing products, including adapting our products forspecific non-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 September 30, 2002 to $3.3 million for the threemonths ended September 30, 2003. Research and development expensesdecreased from $11.4 million for the nine months ended September 30, 2002,to $10.3 million for the nine months ended September 30, 2003.  The decrease was related to lower headcountdue to our 2002 and 2003 restructuring plans and lower depreciationexpense.  Currently, all costs relatedto research and development of our products are charged to research anddevelopment 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 professionalservices fees. General and administrative expenses increased from$1.4 million for the three months ended September 30, 2002 to $1.5million for the three months ended September 30, 2003.  General and administrative expensesincreased from $4.2 million for the nine months ended September 30, 2002,to $4.4 million for the nine months ended September 30, 2003.  We believe our general and administrativeexpenses will remain constant or be slightly higher in the remainder of 2003over 2002 due to increased costs from our new headquarters building.

 

*Restructuring Charges.* For the nine monthsended September 30, 2003, we incurred $3.2 million in restructuringcharges related to the restructuring of our European operations and relocationof our worldwide headquarters. For the nine months ended September 30, 2002, weincurred $682,000 of restructuring charges related to a general headcountreduction.

 

InFebruary 2003, we announced our plan to downsize and reorganize resourcesin Europe, the Middle East, and the African (“EMEA”) region.  Our French office was significantlyaffected.  Of the 20 positions

 

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located in France, sevenpositions were transferred to other EMEA offices, eight positions wereeliminated, two positions remain to be eliminated and three positions remain inFrance.  We currently anticipate futurecharges of $200,000 to $250,000 related to the EMEA reorganization.

 

Additionally,we moved our world-wide headquarters to a new building in Indianapolis, Indianain 2003.  Effective April 1, 2003,all Indianapolis-based employees, equipment and furniture were relocated to thenew facility.  We continue to owe leasepayments on the previous headquarters through March 1, 2004.  We determined that the remaining leasepayments on the previous headquarters, net of sublease income, qualified asexit costs and were recognized in accordance with SFAS 146 as restructuringcharges.  We subleased approximately 14%of our vacated office space during the quarter ended September 30, 2003 andrecognized scheduled lease payments over the sublease life during the quarterended September 30, 2003 of $118,000. We do not anticipate additional exit charges related to our previousheadquarters.

 

*Interestincome, net*

 

Interestincome, net decreased from $86,000 for the three months endedSeptember 30, 2002 to $36,000 for the three months ended September 30,2003.  Interest income, net decreasedfrom $319,000 for the nine months ended September 30, 2002, to $132,000for the nine months ended September 30, 2003.  Both decreases resulted from a combination of a decrease ineffective interest rates and less invested cash.

 

*Incometaxes*

 

ForU.S. corporate income tax purposes, we did not recognize a tax benefit relatedto U.S. federal or state income taxes during the three or nine months endedSeptember 30, 2002 or September 30, 2003 because of the uncertaintyof eventually realizing the benefits of our operating losses. However, we didrecognize tax expense related to our international operations of $50,000 and$54,000 for the three months ended September 30, 2002, andSeptember 30, 2003, respectively, and tax expense of $150,000 and $179,000for the nine months ended September 30, 2002 and September 30, 2003,respectively.

 

Asdescribed in Note 4 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 encompassing the years 1998,1999, 2000, and 2001.  The totalassessment is approximately 2.6 million Euros or approximately $3.0 million.  We are appealing the assessment, but cannotassure you that this matter will be resolved without litigation, that it willnot take several years to resolve or that we will not have to pay some or allof the assessment.

 

*Liquidityand Capital Resources*

 

As ofSeptember 30, 2003, we had cash and cash equivalents of$12.1 million, $3.0 million in short term investments and a workingcapital deficit of $2.2 million. Excluding liabilities related to deferred revenues of $20.6 million fromthe working capital calculation, we have a working capital balance of $18.4million.

 

Ouroperating activities resulted in a net cash inflow of $1.9 million for thenine month period ended September 30, 2003, and a net cash outflow of$2.7 million for the nine month period ended September 30, 2002. Thenet operating cash inflow for the first nine months of 2003 was primarily theresult of our net loss, offset by non-cash depreciation, a decrease in accountsreceivable, and an increase in accounts payable (primarily related torestructuring charges).  The netoperating cash outflow for the first nine months of 2002 was primarily theresult of our operating loss and a decrease in deferred revenues, partiallyoffset by the non-cash depreciation amount and a decrease in accountsreceivable.

 

Ourinvesting activities have consisted primarily of capital expenditures forproperty and equipment and purchases and sales of investments. Our investingactivities resulted in a $4.0 million inflow for the nine month period endedSeptember 30, 2003 and a $6.6 million outflow for the nine month periodended

 

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September 30, 2002.The inflow for the first nine months of 2003 was attributed to the net sale ofavailable-for-sale investments, partially offset by capital expenditures forproperty and equipment. The net outflow for the first nine months of 2002 wasattributable to net purchases of available-for-sale investments and capitalexpenditures for property and equipment. At September 30, 2003, we do not have any material commitments forfuture capital expenditures.

 

InApril 2001, we entered into a non-cancelable operating lease agreement fora new, approximately 120,000 square foot, corporate headquarters building thatwe moved into in April 2003.  Overthe life of the 15 year lease, we are committed to expend approximately $35.1million in rent payments.

 

Forthe nine months ended September 30, 2003, we generated $270,000 fromfinancing activities, which was attributable to both the issuance of commonstock and stock option exercises.  Forthe nine months ended September 30, 2002 we generated $447,000, which wasrelated to both the issuance of common stock and stock option exercises.

 

Webelieve that our existing cash and cash equivalents and short-term investmentswill be sufficient to meet our working capital and capital expenditurerequirements for at least the next 12 months. After that time, we mayrequire additional funds to support our working capital requirements or forother corporate purposes, and we may seek to raise additional funds throughpublic or private equity or debt financings or from other sources. We cannotassure you that additional financing will be available at all or that, ifavailable, it will be on terms favorable to us or that any additional financingwill not dilute your ownership interestin the Company.

 

*RecentlyIssued Accounting Standards*

 

InApril 2003, the FASB issued SFAS No. 149, *Amendmentof Statement 133 on Derivative Instruments and Hedging Activities*.  SFAS No. 149 amends and clarifies accountingfor derivative instruments, including certain derivative instruments embeddedin other contracts, and for hedging activities under SFAS No. 133, *Accounting for Derivative Instruments and HedgingActivities*.  In particular,SFAS No. 149 clarifies under what circumstances a contract with an initial netinvestment meets the characteristics of a derivative and when a derivativecontains a financing component that warrants special reporting in the statementof cash flows.  SFAS No. 149 isgenerally effective for contracts entered into or modified after June 30,2003 and is not expected to have a material impact on the Company’s financialposition or results of operations.

 

InMay 2003, the FASB issued SFAS No. 150, *Accountingfor Certain Financial Instruments with Characteristics of both Liabilities andEquity*.  SFAS No. 150establishes standards for how an issuer classifies and measures in itsstatement of financial position certain financial instruments withcharacteristics of both liabilities and equity.  It requires that an issuer classify a financial instrument thatis within the scope as a liability (or an asset in some circumstances) becausethat financial instrument embodies an obligation of the issuer.  SFAS No. 150 is effective for financialinstruments entered into or modified after May 31, 2003, and otherwise iseffective at the beginning of the first interim period beginning afterJune 15, 2003.  Adoption of thisstatement did not have a significant impact on the Company’s financial positionor results of operations.

 

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

 

**THEOVERALL ECONOMIC CLIMATE MAY 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 is weak, demand for our products coulddecrease, resulting in lower revenues.

 

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**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 September 30, 2003, we hadaccumulated net losses since inception of $60.1 million. We intend tocontinue 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 may continue to experiencelosses and/or negative cash flow from operations in future quarters.

 

**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**

 

Ouroperating results have varied significantly from quarter to quarter and maycontinue to do so in the future depending on a number of factors affecting usor our industry, including many that are beyond our control. As a result, webelieve 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. In addition, our operating results in a future quarter orquarters may fall below expectations of securities analysts or investors and,as a result, 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 to reduceor modify, our business, financial condition or results of operations could bematerially adversely affected if revenues do not meet our expectations.

 

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, ANDMAY CONTINUE TO CONTRIBUTE, TO THE QUARTER-TO-QUARTER VARIABILITY OF OURREVENUES AND OPERATING RESULTS, WHICH COULD AFFECT THE MARKET PRICE OF OURCOMMON STOCK**

 

Wehave generally experienced a lengthy product sales cycle, averaging approximatelysix to nine months. The lengthy sales cycle is one of the factors that hascaused, and may in the future continue to cause, our software revenues andoperating results to vary significantly from quarter to quarter, which couldaffect the market price of our common stock. It also makes it difficult for usto forecast product license revenues. Because of the unique characteristics ofour products, our prospective end-user customers’ decisions to license ourproducts often require significant investment and executive level decisionmaking. We believe that many companies currently are not aware of the benefitsof interaction management software of the type we license or of our productsand capabilities. For this reason, we must provide a significant level ofeducation to prospective end-user customers about the use and benefits of ourproducts, which can cause potential end-user customers to take many months tomake these decisions. As a result,

 

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sales cycles for end-usercustomer orders vary substantially from customer to customer. Excessive delayin product sales could materially adversely affect our business, financialcondition or results 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:

 

•                  an end-usercustomer’s budgetary constraints;

 

•                  the timing of anend-user customer’s budget cycles;

 

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

 

•                  downturns ingeneral economic conditions, including reductions in demand for call centerservices.

 

Inaddition, the sales cycle for our products in international markets has been,and is expected to continue to be, longer than the sales cycle in the UnitedStates. The average sales cycle for our products may lengthen as we expandinternationally.

 

**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 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 SUCCESSFULRELATIONSHIPS WITH OUR RESELLERS AND OEM PARTNERS AND CONTINUE TO RECRUIT ANDDEVELOP ADDITIONAL SUCCESSFUL RESELLERS AND OEM PARTNERS**

 

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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 USTO INCUR 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 THEINTERNET**

 

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 viability due to delays in the development oradoption of new standards and protocols to handle increased activity or due toincreased government regulation and taxation of Internet 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

 

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Server®. A decline inmarket acceptance for Microsoft technologies or the increased acceptance ofother server technologies could cause us to incur significant development costsand could have a material adverse effect on our ability to market our currentproducts. Although we believe that Microsoft technologies will continue to bewidely used by businesses, we cannot assure you that businesses will adoptthese technologies 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 andrelated services, neither of which can be assured. If our end-user customers donot perceive our products or related services to be effective or of highquality, our brand and name recognition would suffer which could have amaterial adverse effect on our business, financial condition or results ofoperations.

 

**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 andannual maintenance fees. There can be no

 

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assurance that currentinstalled customers will pay annual renewal fees or annual maintenance fees infuture periods. As a consequence, our operating results, cash flows andliquidity would likely be adversely affected. Our failure to obtain newcustomers or additional orders from existing customers could also materiallyaffect our operating results.

 

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

 

Ourservices revenues are generated primarily from annual renewal fees, annualmaintenance fees, educational services, and professional services. A decreasein our services revenues could follow a decrease in our licenses revenues. Ourability to maintain or increase our services revenues depends in large part onour ability to increase our software licensing activity.

 

**OURMAIN SUPPLIERS OF VOICE PROCESSING BOARDS MAY BECOME UNWILLING OR UNABLETO CONTINUE TO MANUFACTURE AND SUPPLY US WITH VOICE PROCESSING BOARDS,REQUIRING US TO INTRODUCE A SUBSTITUTE SUPPLIER WHICH COULD PROVE DIFFICULT ORCOSTLY**

 

IntelCorporation (who acquired Dialogic Corporation) and AcuLab plc are our primarysuppliers of the voice processing boards that are used by a majority of ourend-user customers for the operation of our products. If a majority of futureend-user customers desire to utilize the voice processing boards to enable ourproducts and these suppliers become unable or unwilling to continue tomanufacture and supply these voice processing boards in the volume, price andtechnical specifications we require, then we would have to adapt our productsto a substitute supplier. We may not be able to successfully introduce voiceprocessing boards made by a substitute supplier into the available versions of ourproducts. In addition, introducing a substitute supplier of voice processingboards could result in unforeseen additional product development orcustomization costs and could also introduce hardware and software operating orcompatibility problems. We cannot assure you that these issues will not affectproduct shipments, will not be costly to correct, will not damage ourreputation in the markets in which we operate, or will not have a materialadverse affect on our business, financial condition or results of operations.

 

**WEMAY NOT BE ABLE TO PROTECT OUR PROPRIETARY RIGHTS ADEQUATELY, WHICH COULDALLOW THIRD 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. Wecurrently hold three patents and have filed numerous other patent applicationsrelating to technology embodied in our software

 

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products. We hold 17 U.S.trademark registrations and 28 foreign trademark registrations and havenumerous other trademark applications pending worldwide, as well as havingcommon law rights in other trademarks and service marks. We hold one registeredcopyright. It may be possible for a third party to copy or otherwise obtain anduse our technology without authorization. A third party could also developsimilar technology independently. In addition, the laws of some countries inwhich we sell our products do not protect our software and intellectualproperty rights to the same extent as the laws of the United States.Unauthorized copying, use or reverse engineering of our products could materiallyadversely affect our business, 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**

 

Thirdparties have claimed or may in the future claim that our technology infringestheir proprietary rights. As the number of software products in our targetmarkets increases and the functionality of these products overlap, we believethat software developers may face additional infringement claims.  See Note 4 of our Notes to CondensedConsolidated Financial Statements for a description of contingencies.

 

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systems. Although we believethat our products do not infringe any of these patents because, among otherreasons, our products are designed to replace PBXs and not to create suchinterfaces, if these patents were interpreted broadly, claims of infringementof these patents could have a material adverse affect on us.

 

Infringementclaims, even if without merit, can be time consuming and expensive todefend.  A third party assertinginfringement claims against us or our customers with respect to our current orfuture products may require us to enter into costly royalty arrangements orlitigation, or otherwise materially adversely affect us.

 

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

 

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, financialcondition or results of operations.  Ourfuture success also depends on our ability to attract, train, assimilate andretain additional qualified personnel. Competition for persons with skills in the software industry is intense,particularly for those with relevant technical and/or sales experience. Wecannot assure you that we will be able to retain our key employees or that wecan attract, train, assimilate or retain other highly qualified personnel inthe future.

 

Also,in connection with our effort to streamline operations, reduce costs andrationalize our staffing and structure, we initiated headcount reductions inboth 2001 and 2002 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 headcountreductions. As a result, our ability to respond to unexpected challenges may beimpaired and we may be unable to take advantage of new opportunities. Thesereductions 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 THATMAY NOT BE SUCCESSFUL**

 

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:

 

•                  We cannot assurethat any acquired businesses will achieve anticipated revenues, earnings orcash flow.

 

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

 

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

 

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•                  We may financefuture acquisitions by issuing common stock for some or all of the purchaseprice. This could dilute the ownership interests of our stockholders. We mayalso incur additional debt or be required to recognize amortization expenserelated to other intangible assets purchased in future acquisitions.

 

•                  We would becompeting with other firms, many of which have greater financial and otherresources, to acquire attractive companies. We believe this competition willincrease, making it more difficult to acquire suitable companies on acceptableterms.

 

**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 nine monthsended September 30, 2003, and for the years ended 2002, 2001, and 2000,respectively. To date, our products have been licensed outside North Americaprimarily in Western Europe, South Africa, and Australia. We also havemarketing efforts in Japan, Korea, China and Central and South America. Weintend to continue to emphasize our international operations and we may enteradditional international markets. Revenues from international operations may beinadequate to cover the expenses of those operations. In addition to foreigncurrency fluctuation risks described in the next risk factor, other risksinherent in our international business activities, in the countries in which wehave licensed our products to date and in those countries in which we operateand could expand into, generally could include the following:

 

•                  economic andpolitical instability;

 

•                  unexpectedchanges in foreign regulatory requirements and laws;

 

•                  tariffs andother trade barriers;

 

•                  timing, cost andpotential difficulty of adapting our software products to the local language inthose foreign countries that do not use the alphabet that English uses, such asJapan, Korea and China;

 

•                  lack ofacceptance of our products in foreign countries;

 

•                  longer salescycles and accounts receivable payment cycles;

 

•                  potentiallyadverse tax consequences;

 

•                  restrictions onthe repatriation of funds; and

 

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

 

**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.

 

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Exchange rate fluctuationscould also make our products more expensive than competitive products notsubject to these fluctuations, which could adversely affect our revenues andprofitability 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 provisionsdesigned to limit our exposure to potential product liability and some contractclaims. However, not all of these agreements contain these types of provisionsand, where present, these provisions vary as to their terms and may not beeffective under the laws of some jurisdictions. A product liability, warranty,or other claim brought against us could have a material adverse effect on ourbusiness, financial condition or results of operations.

 

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 be availableas required for acquisitions or other needs. Even if financing is available, itmay not be on terms that are favorable to us or sufficient for our needs. If weare unable to obtain sufficient financing, we may be unable to fully implementour 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:

 

•                  actual oranticipated fluctuations in our operating results;

 

•                  announcements byus, our competitors or our end-user customers;

 

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

 

•                  technologicalinnovations by others;

 

•                  the operatingand stock price performance of other comparable companies or of our competitorsor end-user customers;

 

•                  the low numberof our shares typically traded in any trading session;

 

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•                  the availabilityfor future sale, or sales, of a substantial number of shares of our commonstock in the public market; and

 

•                  general marketor 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.

 

**OURCOMMON STOCK IS SUBJECT TO VARIOUS LISTING REQUIREMENTS**

 

Thevarious markets operated by The Nasdaq Stock Market have quantitativemaintenance criteria for continued listing of common stock. We may be delistedfrom one or more Nasdaq markets if we fail to comply with the criteria.  While we believe that we currently meetcriteria for a market operated by The Nasdaq Stock Market, we can offer noassurance that our common stock will continue to meet the various criteria forcontinued listing on any market operated by The Nasdaq Stock Market.  Any delisting may result in a reduction inthe liquidity of our common stock, which may have a material adverse effect onthe price of our common stock.  

 

**REGULATORYCHANGES MADE TO GENERALLY ACCEPTED ACCOUNTING PRINCIPLES OR CORPORATEGOVERNANCE MATTERS 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. In addition, legislative changes and the perception these changes createcan have a material, adverse effect on our business.  For example:

 

•                  Pending or newlegislation may lead to an increase in our costs related to audits inparticular and regulatory compliance generally;

 

•                  Pending or newlegislation may force us to seek other service providers for non-audit-relatedservices, which may raise costs; and

 

•                  Changes in thelegal 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 theavailability of key personnel and physical assets. Additionally, terrorist actsmay cause uncertainty about business continuity and the effectiveness of ourdisaster recovery plans and the disaster recovery plans of our suppliers andresellers, and may adversely affect the confidence and behavior of ourcustomers, employees, suppliers, and resellers.

 

**WECANNOT PREDICT EVERY EVENT AND CIRCUMSTANCE THAT MAY IMPACT OUR BUSINESSAND, THEREFORE, THE RISKS AND UNCERTAINTIES DISCUSSED ABOVE MAY NOT BE THEONLY ONES YOU 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.

 

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**Item3. Quantitative and QualitativeDisclosures about Market Risk.**

 

We develop products inthe United States and sell licenses in North America, Europe, the Asia/Pacificregion, South Africa, and Central and South America. As a result, our financialresults could be affected by various factors, including changes in foreigncurrency exchange rates or weak economic conditions in foreign markets. As mostsales are currently made in U.S. dollars, a strengthening of the dollar couldmake our products less competitive in foreign markets.  Additionally, as 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 onus.

 

We manage our interest rate risk by maintaining an investment portfoliowith debt instruments of high credit quality and relatively short averagematurities. We also manage interest rate risk by maintaining sufficient cashand cash equivalent balances such that we are typically able to hold ourinvestments to maturity.

 

**Item 4.  Controls andProcedures**

 

We maintain a set of disclosure controls and procedures that aredesigned to ensure that information required to be disclosed by us in thereports filed by us under the Securities Exchange Act of 1934, as amended(“Exchange Act”) is recorded, processed, summarized and reported within thetime periods specified in the SEC’s rules and forms.  We carried out an evaluation, under the supervision and with theparticipation of our management, including our President and Chief ExecutiveOfficer and our Chief Financial Officer and Treasurer, of the effectiveness ofthe design and operation of our disclosure controls and procedures as of September 30,2003 pursuant to Rule 13a-15(b) of the Exchange Act.  Based on that evaluation, our President and Chief ExecutiveOfficer and our Chief Financial Officer and Treasurer concluded that ourdisclosure controls and procedures are effective.

 

There have been no changes in our internal control over financialreporting that occurred during the quarter ended September 30, 2003 thathave materially affected, or are reasonably likely to materially affect, ourinternal control over financial reporting.

 

**PARTII. OTHER INFORMATION**

 

**Item 1. Legal Proceedings.**

 

On September 30, 2003, Recursion Software, Inc. filed suit in Dallas,Texas County court against the Company alleging breach of contract and moneydue under claims of quantum meruit and unjust enrichment.  Recursion claims that the Companyincorporated Recursion Software into one of the Company’s products in breach ofthe underlying license.  No dollaramount has been stated in the action. The Company believes that it has strong defenses to the claims and it intendsto vigorously defend against the action.

 

The Company is also subject to various legal proceedings and claimsthat arise in the normal course of business. While the outcome of theseproceedings and claims cannot be predicted with certainty, management does notbelieve that the outcome of any of these legal matters will have a materialadverse effect on the Company’s business, operating results or financialcondition. However, litigation in general, and intellectual property litigationin particular, can be expensive and disruptive to normal business operations.Moreover, the results of complex legal proceedings are difficult to predict.

 

See Note 4 of our Notes to the Condensed Consolidated FinancialStatements for a description of contingencies.

 

 

**Item5. Other Information**

 

Effective September 22, 2003, Randall L. Tobias resigned from ourBoard of Directors and related committees. He advised us that his resignation was in anticipation of hisappointment by the President of the United States to serve as his Ambassadorand Global Aids Coordinator.

 

Effective November 14, 2003, Stephen R. Head has been named as ourChief Financial Officer.  He replacesKeith A. Midkiff, who has resigned as our Chief Financial Officer, CorporateSecretary and Treasurer effective that same date.  Mr. Head has been Chief Financial Officer for Web securityapplications developer, Gilian Technologies Ltd., since 2001, and was ChiefFinancial Officer for e-commerce company, planet U, Inc., from 1999 to2001.  Prior to that, he held positionsof Vice President of Finance and Chief Financial Officer for Indianapolis-basedMade2Manage Systems, Inc. and Software Artistry, Inc.  Mr. Head began his career in public

 

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accounting with KPMG LLP, holds an M.B.A. degree from IndianaUniversity, and is a certified public accountant.

 

**Item 6. Exhibits and Reports on Form 8-K.**

 

(a)          Exhibits

 

10.9 Employment Agreement between the Company and Donna LeGrand datedAugust 11, 2003

 

31.1  Certificationof the Chief Executive Officer pursuant to Rule 13a-14(a)/15d-14(a) of theSecurities Exchange Act of 1934, as adopted pursuant to Section 302 of theSarbanes-Oxley Act of 2002

 

31.2 Certification of the Chief Financial Officer pursuant to Rule 13a-14(a)/15d-14(a)of the Securities Exchange Act of 1934, as adopted pursuant to Section 302of the Sarbanes-Oxley Act of 2002

 

32.1 Certification of Donald E. Brown, M.D., CEO, pursuant to 18 U. S.C. Section 1350, as adopted pursuant to Section 906 of theSarbanes-Oxley Act of 2002

 

32.2 Certification of Keith A. Midkiff, CFO, pursuant to 18 U. S. C.Section 1350, as adopted pursuant to Section 906 of theSarbanes-Oxley Act of 2002

 

(b)         Reports on Form 8-K

 

1.  OnJuly 22, 2003, the Company furnished, not filed, a Form 8-K attaching apress release describing its results of operations for the quarter endedJune 30, 2003.

 

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**SIGNATURES**

 

Pursuant to the requirements of the Securities Exchange Act of 1934,the Registrant has duly caused this report to be signed on its behalf by theundersigned thereunto duly authorized.

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

 

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