** **

**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

 

**Washington, D.C. 20549**

 

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**FORM 10-Q**

 

| **(Mark One)**                                                                                                                                                                                                            |                                                                                          |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|-----------------------------------------------------------------------------------------------|
|                                                                                                                                                                                                                      |                                                                                          |
| **ý**                                                                                                                                                                                                                | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)  OF THE SECURITIES EXCHANGE ACT OF 1934**  |
| ** **                                                                                                                                                                                                                | ** **                                                                                    |
| **For the quarterly period ended September  30, 2004**                                                                                                                                                                    |
| ** **                                                                                                                                                                                                                | ** **                                                                                    |
| **Or**                                                                                                                                                                                                                    |
| ** **                                                                                                                                                                                                                | ** **                                                                                    |
| **o**                                                                                                                                                                                                                     | **TRANSITION REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
| ** **                                                                                                                                                                                                                | ** **                                                                                    |
| **For the transition period  from               to               ** |
| ** **                                                                                                                                                                                                                | ** **                                                                                    |
| **Commission File Number 000-27385**                                                                                                                                                                                      |
|                                                                                                                                                                                                                           |                                                                                               |  |

 

**INTERACTIVE INTELLIGENCE, INC.**

**(Exact name of registrant as specified in itscharter)**

 
| **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 Act of1934 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, 2004was 15,898,102.

 

 

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TABLE OF CONTENTS

 
| PART I. FINANCIAL INFORMATION |                                                                                                                          |
|-------------------------------|-------------------------------------------------------------------------------------------------------------------------------|
|                          |                                                                                                                          |   |
| Item 1.                       | Condensed Consolidated Balance Sheets as of  September 30, 2004 (unaudited) and December 31, 2003                             |   |
|                          |                                                                                                                          |   |
|                          | Condensed  Consolidated Statements of Operations for the three and nine months ended  September 30, 2004 and 2003 (unaudited) |   |
|                          |                                                                                                                          |   |
|                          | Condensed  Consolidated Statement of Shareholders’ Equity for the nine months ended  September 30, 2004 (unaudited)      |   |
|                          |                                                                                                                          |   |
|                          | Condensed  Consolidated Statements of Cash Flows for the nine months ended September 30,  2004 and 2003 (unaudited)           |   |
|                          |                                                                                                                          |   |
|                          | Notes to Condensed Consolidated Financial  Statements (unaudited)                                                             |   |
|                          |                                                                                                                          |   |
| 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 6.                       | Exhibits                                                                                                                      |   |
|                          |                                                                                                                          |   |
| SIGNATURES                    |                                                                                                                          |

 

2

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**PART I.FINANCIAL INFORMATION**

 

# **Item1. Condensed Consolidated Financial Statements and Footnotes.**

 

**Interactive Intelligence, Inc.**

**Condensed Consolidated Balance Sheets**

**As of September 30, 2004 and December 31, 2003**

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

** **
| ** **                                                                                                       | ** ** | **September 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|------------------------|------------|
| ** **                                                                                                       | ** ** | **(unaudited)**         | ** ** | ** **             | ** ** |
| ** **                                                                                                       |       |                    |       |                   |       |
| **Assets**                                                                                                       |       |                    |       |                   |       |
| Current assets:                                                                                                  |       |                    |       |                   |       |
| Cash and cash equivalents                                                                                        |       | $                       | 15,646     |                   | $          | 12,461 |   |
| Short-term investments                                                                                           |       | —                  |       | 3,008                  |       |
| Account receivable, net of allowance for  doubtful accounts of $275 in 2004 and $354 in 2003                     |       | 6,448                   |       | 8,956                  |       |
| Prepaid expenses                                                                                                 |       | 1,713                   |       | 1,958                  |       |
| Other current assets                                                                                             |       | 572                     |       | 418                    |       |
| Total current assets                                                                                             |       | 24,379                  |       | 26,801                 |       |
| Property and equipment, net                                                                                      |       | 4,590                   |       | 5,857                  |       |
| Other assets, net                                                                                                |       | 593                     |       | 601                    |       |
| Total assets                                                                                                     |       | $                       | 29,562     |                   | $          | 33,259 |   |
|                                                                                                             |       |                    |       |                   |       |
| **Liabilities and Shareholders’ Equity**                                                                    |       |                    |       |                   |       |
| Current liabilities:                                                                                             |       |                    |       |                   |       |
| Line of credit                                                                                                   |       | $                       | 2,000      |                   | $          | 2,800 |   |
| Accounts payable and accrued liabilities                                                                         |       | 5,587                   |       | 4,544                  |       |
| Accrued compensation and related expenses                                                                        |       | 1,130                   |       | 1,349                  |       |
| Deferred software revenues                                                                                       |       | 4,830                   |       | 8,745                  |       |
| Deferred services revenues                                                                                       |       | 11,586                  |       | 12,030                 |       |
| Total current liabilities                                                                                        |       | 25,133                  |       | 29,468                 |       |
| Shareholders’ equity:                                                                                       |       |                    |       |                   |       |
| Preferred stock, no par value: 10,000,000  authorized; no shares issued and outstanding                          |       | —                  |       | —                 |       |
| Common stock, $0.01 par value; 100,000,000  authorized;                                                          |       |                    |       |                   |       |
| 15,872,532 issued and outstanding at  September 30, 2004, 15,755,477 issued and outstanding at December 31, 2003 |       | 158                     |       | 157                    |       |
| Additional paid-in capital                                                                                       |       | 65,080                  |       | 64,696                 |       |
| Accumulated other comprehensive income                                                                           |       | 7                       |       | 280                    |       |
| Accumulated deficit                                                                                              |       | (60,816                 | )          | (61,342                | )          |
| Total shareholders’ equity                                                                                  |       | 4,429                   |       | 3,791                  |       |
| Total liabilities and shareholders’ equity                                                                  |       | $                       | 29,562     |                   | $          | 33,259 |   |

 

See Notes to Condensed Consolidated Financial Statements

 

3

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# **Interactive Intelligence, Inc.**

# **CondensedConsolidated Statements of Operations**(unaudited)

**For the Three and Nine Months Ended September30, 2004 and 2003**

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

** **
| ** **                                           | ** ** | **Three Months Ended   September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|------------------------------------------------------|------------|----------------------------------------|------------|--------------------------------------|------------|
| ** **                                           | ** ** | **2004**                               | ** ** | **2003**                             | ** ** | **2004** | ** ** | **2003** |   |
| Revenues:                                            |       |                                   |       |                                 |       |   |   |   |   |
| Software                                             |       | $                                      | 6,591      |                                 | $          | 5,684 |   | $ | 20,841 |   | $ | 20,077 |   |
| Services                                             |       | 6,823                                  |       | 6,455                                |       | 19,920 |   | 18,553 |   |
| Total revenues                                       |       | 13,414                                 |       | 12,139                               |       | 40,761 |   | 38,630 |   |
| Cost of revenues:                                    |       |                                   |       |                                 |       |   |   |   |   |
| Software                                             |       | 446                                    |       | 254                                  |       | 1,339 |   | 871 |   |
| Services                                             |       | 2,570                                  |       | 2,962                                |       | 8,200 |   | 9,402 |   |
| Total cost of revenues                               |       | 3,016                                  |       | 3,216                                |       | 9,539 |   | 10,273 |   |
| Gross profit                                         |       | 10,398                                 |       | 8,923                                |       | 31,222 |   | 28,357 |   |
| Operating expenses:                                  |       |                                   |       |                                 |       |   |   |   |   |
| Sales and marketing                                  |       | 5,301                                  |       | 5,028                                |       | 15,405 |   | 15,145 |   |
| Research and development                             |       | 3,208                                  |       | 3,322                                |       | 9,744 |   | 10,289 |   |
| General and administrative                           |       | 1,777                                  |       | 1,546                                |       | 5,370 |   | 4,358 |   |
| Restructuring and other charges                      |       | —                                 |       | 34                                   |       | 101 |   | 3,172 |   |
| Total operating expenses                             |       | 10,286                                 |       | 9,930                                |       | 30,620 |   | 32,964 |   |
| Operating income (loss)                              |       | 112                                    |       | (1,007                               | )          | 602 |   | (4,607 | ) |
| Interest income, net                                 |       | 28                                     |       | 36                                   |       | 60 |   | 132 |   |
| Income (loss) before income taxes                    |       | 140                                    |       | (971                                 | )          | 662 |   | (4,475 | ) |
| Income taxes                                         |       | 38                                     |       | 54                                   |       | 136 |   | 150 |   |
| Net income (loss)                                    |       | $                                      | 102        |                                 | $          | (1,025 | ) | $ | 526 |   | $ | (4,625 | ) |
|                                                 |       |                                   |       |                                 |       |   |   |   |   |
| Net income (loss) per share:                         |       |                                   |       |                                 |       |   |   |   |   |
| Basic                                                |       | $                                      | 0.01       |                                 | $          | (0.07 | ) | $ | 0.03 |   | $ | (0.30 | ) |
| Diluted                                              |       | 0.01                                   |       | (0.07                                | )          | 0.03 |   | (0.30 | ) |
|                                                 |       |                                   |       |                                 |       |   |   |   |   |
| Shares used to compute net income (loss)  per share: |       |                                   |       |                                 |       |   |   |   |   |
| Basic                                                |       | 15,872                                 |       | 15,638                               |       | 15,841 |   | 15,601 |   |
| Diluted                                              |       | 16,476                                 |       | 15,638                               |       | 16,637 |   | 15,601 |   |

 

See Notes to Condensed Consolidated Financial Statements

 

4

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# **Interactive Intelligence, Inc.**

# **Condensed ConsolidatedStatement of Shareholders’**Equity (unaudited)

**For the Nine Months Ended September 30, 2004**

# **(in thousands)**

 
| ** **                           | ** ** | **Common Stock** | ** ** | **Additional  Paid-in  Capital** | ** ** | **Accum. Other  Comprehensive  Income** | ** ** | **Accumulated  Deficit** | ** ** | **Total** | ** ** |
|--------------------------------------|------------|------------------|------------|----------------------------------|------------|-----------------------------------------|------------|--------------------------|------------|-----------|------------|
| ** **                           | ** ** | **Shares**       | ** ** | **Amount**                       |
|                                 |       |             |       |                             |       |                                    |       |                     |       |      |       |   |   |
| Balances, December 31, 2003          |       | 15,755           |       | $                                | 157        |                                    | $          | 64,696                   |       | $         | 280        |   | $ | (61,342 | ) | $ | 3,791 |   |
|                                 |       |             |       |                             |       |                                    |       |                     |       |      |       |   |   |
| Issuances of common stock            |       | 60               |       | 1                                |       | 213                                     |       | —                   |       | —    |       | 214 |   |
| Exercise of stock options            |       | 58               |       | —                           |       | 163                                     |       | —                   |       | —    |       | 163 |   |
| Amortization of deferred stock-based |       |             |       |                             |       |                                    |       |                     |       |      |       |   |   |
| compensation                         |       | —           |       | —                           |       | 8                                       |       | —                   |       | —    |       | 8 |   |
| Comprehensive income:                |       |             |       |                             |       |                                    |       |                     |       |      |       |   |   |
| Foreign currency fluctuation         |       | —           |       | —                           |       | —                                  |       | (273                     | )          | —    |       | (273 | ) |
| Net income                           |       | —           |       | —                           |       | —                                  |       | —                   |       | 526       |       | 526 |   |
| Total comprehensive income           |       | —           |       | —                           |       | —                                  |       | (273                     | )          | 526       |       | 253 |   |
|                                 |       |             |       |                             |       |                                    |       |                     |       |      |       |   |   |
| Balances, September 30, 2004         |       | 15,873           |       | $                                | 158        |                                    | $          | 65,080                   |       | $         | 7          |   | $ | (60,816 | ) | $ | 4,429 |   |

 

See Notes to Condensed Consolidated Financial Statements

 

5

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# ** **

# **Interactive Intelligence, Inc.**

# **Condensed ConsolidatedStatements of Cash Flows**(unaudited)

**For the Nine Months Ended September 30, 2004and 2003**

# **(in thousands)**

 
| ** **                                                          | ** ** | **Nine Months Ended  September 30,** | ** ** |
|---------------------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                                          | ** ** | **2004**                             | ** ** | **2003** |   |
| **Operating activities:**                                           |       |                                 |       |   |   |
| Net income (loss)                                                   |       | $                                    | 526        |   | $ | (4,625 | ) |
| Adjustments to reconcile net income (loss)  to net cash provided by |       |                                 |       |   |   |
| operating activities:                                               |       |                                 |       |   |   |
| Depreciation                                                        |       | 2,383                                |       | 3,464 |   |
| Amortization of deferred stock-based  compensation                  |       | 8                                    |       | 79 |   |
| Loss on disposal of fixed assets                                    |       | —                               |       | 539 |   |
| Changes in operating assets and  liabilities:                       |       |                                 |       |   |   |
| Accounts receivable                                                 |       | 2,508                                |       | 1,896 |   |
| Prepaid expenses                                                    |       | 245                                  |       | 706 |   |
| Other current assets                                                |       | (427                                 | )          | (168 | ) |
| Other assets                                                        |       | 8                                    |       | 321 |   |
| Accounts payable and accrued liabilities                            |       | 1,043                                |       | 1,450 |   |
| Accrued compensation and related expenses                           |       | (219                                 | )          | (109 | ) |
| Deferred software revenues                                          |       | (3,915                               | )          | (3,024 | ) |
| Deferred services revenues                                          |       | (444                                 | )          | 1,679 |   |
| Net cash provided by operating activities                           |       | 1,716                                |       | 2,208 |   |
|                                                                |       |                                 |       |   |   |
| **Investing activities:**                                           |       |                                 |       |   |   |
| Purchases of property and equipment                                 |       | (1,116                               | )          | (2,717 | ) |
| Sales of available-for-sale investments                             |       | 3,008                                |       | 6,410 |   |
| Net cash provided by investing activities                           |       | 1,892                                |       | 3,693 |   |
|                                                                |       |                                 |       |   |   |
| **Financing activities:**                                           |       |                                 |       |   |   |
| Payments on line of credit, net                                     |       | (800                                 | )          | — |   |
| Proceeds from issuance of common stock                              |       | 214                                  |       | 245 |   |
| Proceeds from stock options exercised                               |       | 163                                  |       | 25 |   |
| Net cash provided (used) by financing  activities                   |       | (423                                 | )          | 270 |   |
|                                                                |       |                                 |       |   |   |
| Net increase in cash and cash equivalents                           |       | 3,185                                |       | 6,171 |   |
| Cash and cash equivalents, beginning of  period                     |       | 12,461                               |       | 5,913 |   |
| Cash and cash equivalents, end of period                            |       | $                                    | 15,646     |   | $ | 12,084 |   |
|                                                                |       |                                 |       |   |   |
| Cash paid for interest                                              |       | $                                    | 18         |   | $ | 7 |   |
| Cash paid for taxes                                                 |       | 2                                    |       | 2 |   |

** **

See Notes to Condensed Consolidated Financial Statements 

 

6

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**Interactive Intelligence, Inc.**

**Notes To Condensed Consolidated Financial****Statements**

# **September 30, 2004 and 2003 (unaudited)**

 

# **1.     Description of Business andBasis of Presentation**

 

InteractiveIntelligence, Inc. (the “Company”) is a leading provider of softwareapplications for contact centers and is leveraging that leadership position toprovide mission critical voice over Internet protocol (VoIP) applications toenterprises. The Company sells into four distinct markets, all of whose needsare increasing for VoIP-based systems:

•                  Contact Centers

•                  Enterprise IP Telephony

•                  Unified Communications, and

•                  Self-service Automation.

 

The Company’sprincipal competitors are hardware vendors who offer proprietary approachesusing a combination of phone systems, call distributors, voicemail systems, andinteractive voice response (IVR) systems equipment. The Company offers asoftware solution based on Microsoft Windows that resides on a customer’snetwork and uses open Session Initiation Protocol (SIP) for VoIP networking.This open approach typically results in lower overall costs for phone devices,system maintenance, and customer networking. The Company’s softwareapplications are also pre-integrated into many popular business applicationssuch as financial, customer relationship management (CRM) and enterpriseresource planning (ERP) software, thereby automating and tracking businesstransactions to customer interactions. The Company is best known for itsbundled suite of contact center applications that includes multi-media customercontact for phone calls, Web chat, Web callback, e-mail queuing, customerdefined queues, and integrated speech recognition applications.

 

Principaloperations of the Company commenced during 1997. The Company currently marketsits software applications in: the Americas; Europe, Middle East and Africa(EMEA); and Australia and other Asia/Pacific countries (APAC). Besides itscorporate headquarters in Indianapolis, Indiana, the Company has establishedwholly-owned subsidiaries in Australia, France, the Netherlands and the UnitedKingdom. In addition, the Company has branch offices in Canada, Germany, HongKong, Japan, Korea, Malaysia, Singapore and Sweden.

 

In June 2004,the Company released the newest version of its product, version 2.3, whichunderlies the Customer Interaction Center (CIC), Enterprise Interaction Center(EIC) and other applications. This version addresses reliability andscalability of the applications and provides for simplified installation andmaintenance of all of the Company’s software applications.

 

On July 1,2004, the Company formed a wholly-owned subsidiary, Vonexus, Inc. (Vonexus),which is responsible for the development, marketing and distribution of theCompany’s EIC application. EIC is the Company’s standards-based all-software IPPBX that is offered as part of a complete telephony solution forMicrosoft-centric small and medium-sized businesses.

 

Theaccompanying unaudited financial statements have been prepared in conformitywith accounting principles generally accepted in the United States of Americafor interim financial information and with the instructions for Form 10-Q andArticle 10 of Regulation S-X. Accordingly, certain information and footnotedisclosures normally included in financial statements prepared in accordancewith accounting principles generally accepted in the United States of Americahave been condensed, or omitted, pursuant to the rules and regulations of theSecurities and Exchange Commission. In our opinion, the statements include alladjustments necessary (which are of a normal and recurring nature) for the fairpresentation of the results of the interim periods presented.

 

7

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The balancesheet at December 31, 2003 has been derived from the audited financialstatements at that date but does not include all of the information andfootnotes required by accounting principles generally accepted in the UnitedStates of America for complete financial statements.

 

Thesefinancial statements should be read in conjunction with our auditedconsolidated financial statements for the year ended December 31, 2003,included in the Company’s Form 10-K for the year ended December 31, 2003, filedwith the Securities and Exchange Commission on March 25, 2004. Our results ofoperations for any interim period are not necessarily indicative of the resultsof operations for any other interim period or for a full fiscal year.

 

# **2.     Net Income Per Common Share**

 

Basic netincome per share is calculated based on the weighted-average number ofoutstanding common shares in accordance with Financial Accounting StandardsBoard (FASB) Statement No. 128, *Earnings per Share*.Diluted net income per share is calculated based on the weighted-average numberof outstanding common shares plus the effect of dilutive potential commonshares.

 

The followingtable presents the calculation of basic and diluted net income per share (inthousands, except per share amounts):

 
| ** **                                               | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|----------------------------------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **                                               | ** ** | **2004**                              | ** ** | **2003**                             | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                                     |       |                                  |       |                                 |       |   |   |   |   |
| Net income (loss) (A)                                    |       | $                                     | 102        |                                 | $          | (1,025 | ) | $ | 526 |   | $ | (4,625 | ) |
|                                                     |       |                                  |       |                                 |       |   |   |   |   |
| Weighted average outstanding shares of common  stock (B) |       | 15,872                                |       | 15,638                               |       | 15,841 |   | 15,601 |   |
| Dilutive effect of options to purchase  common stock     |       | 604                                   |       | —                               |       | 796 |   | — |   |
| Common stock and common stock equivalent shares  (C)     |       | 16,476                                |       | 15,638                               |       | 16,637 |   | 15,601 |   |
|                                                     |       |                                  |       |                                 |       |   |   |   |   |
| Net income (loss) per share:                             |       |                                  |       |                                 |       |   |   |   |   |
| Basic (A/B)                                              |       | $                                     | 0.01       |                                 | $          | (0.07 | ) | $ | 0.03 |   | $ | (0.30 | ) |
| Diluted (A/C)                                            |       | 0.01                                  |       | (0.07                                | )          | 0.03 |   | (0.30 | ) |

 

The Company’scalculation of diluted net income per share for the three months and ninemonths ended September 30, 2004 excludes options to purchase 1.4 million and1.7 million shares of common stock, respectively, with exercise prices rangingfrom $3.29 to $50.50 as their effect would be antidilutive. The Company’scalculation of diluted net loss per share for the three and nine months endedSeptember 30, 2003 excludes all potential common shares as the effect would beantidilutive.

 

# **3.     Stock-Based Compensation**

 

The Companyapplies the intrinsic-value-based method of accounting prescribed by AccountingPrinciples Board (APB) Opinion No. 25, *Accounting for StockIssued to Employees*, and related interpretations including FASBInterpretation No. 44, *Accounting for CertainTransactions involving Stock Compensation, an interpretation of APB Opinion No.25*, to account for its fixed-plan stock options. Under this method,compensation expense is recorded on the date of grant only if the currentmarket price of the underlying stock exceeds the exercise price. FASB StatementNo. 123, *Accounting for Stock-BasedCompensation*and FASBStatement No. 148, *Accounting forStock-Based Compensation – Transition and Disclosure - an amendment of FASBStatement No. 123*, established accounting and disclosurerequirements using a fair-value-based method of accounting for stock-based employeecompensation plans.

 

8

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As permitted by existingaccounting standards, the Company has elected to continue to apply theintrinsic-value-based method of accounting described above, and has adoptedonly the disclosure requirements of FASB Statement No. 123, as amended.

 

For purposes of pro forma disclosures, the estimated fair value of theoptions is amortized to expense on a straight-line basis over the options’vesting period. The table below illustrates the effect on net income (loss) andnet income (loss) per share if the Company had applied the fair valuerecognition provisions of FASB Statement No. 123 to stock-based employeecompensation (in thousands except per share amounts).

 
| ** **                                                                                                                           | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **                                                                                                                           | ** ** | **2004**                              | ** ** | **2003**                             | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                                                                                                                 |       |                                  |       |                                 |       |   |   |   |   |
| Net income (loss), as reported                                                                                                       |       | $                                     | 102        |                                 | $          | (1,025 | ) | $ | 526 |   | $ | (4,625 | ) |
| Add: Stock-based compensation expense  included in reported net income, net of related tax effects                                   |       | —                                |       | 33                                   |       | 8 |   | 79 |   |
| Deduct: Total stock-based compensation  expense determined under fair value based method for all awards, net of  related tax effects |       | (990                                  | )          | (1,287                               | )          | (2,602 | ) | (4,057 | ) |
| Pro forma net loss                                                                                                                   |       | $                                     | (888       | )                                    | $          | (2,279 | ) | $ | (2,068 | ) | $ | (8,603 | ) |
|                                                                                                                                 |       |                                  |       |                                 |       |   |   |   |   |
| Net income (loss) per share:                                                                                                         |       |                                  |       |                                 |       |   |   |   |   |
| Basic – as reported                                                                                                             |       | $                                     | 0.01       |                                 | $          | (0.07 | ) | $ | 0.03 |   | $ | (0.30 | ) |
| Diluted – as reported                                                                                                           |       | 0.01                                  |       | (0.07                                | )          | 0.03 |   | (0.30 | ) |
| Basic – pro forma                                                                                                               |       | (0.06                                 | )          | (0.15                                | )          | (0.13 | ) | (0.55 | ) |
| Diluted – pro forma                                                                                                             |       | (0.06                                 | )          | (0.15                                | )          | (0.13 | ) | (0.55 | ) |

 

# **4.     Concentration of Credit Risk**

# ** **

Onereseller represented 11% of accounts receivable as of September 30, 2004.

 

# **5.     Contingencies**

 

From time totime the Company has received claims from competitors and other technologyproviders claiming that the Company’s technology infringes their respectiveproprietary rights. One such claim has resulted in a legal proceeding beingfiled against the Company, which is described below and another claim hasresulted in the Company accruing an amount, which is described below. Inaddition, the Company is involved in certain legal proceedings in the ordinarycourse of conducting its business. The Company believes these claims and legalproceedings can be resolved without a material adverse effect on its business,financial condition or results of operations; however, the Company cannotprovide assurance as to the outcome. Litigation in general, and intellectualproperty litigation in particular, can be expensive and disruptive to normalbusiness operations. Moreover, the results of complex legal proceedings aredifficult to predict.

 

In 2002, theCompany received a letter from a consulting firm that has been retained by atelecommunication technology provider to develop and implement a licensingprogram based on the technology provider’s patents. The consulting firmbelieves that the Company has infringed on the technology provider’s proprietyrights and therefore feels that a licensing agreement between the Company andthe technology provider is appropriate. The Company believes that it did notinfringe on the technology provider’s proprietary rights; however, because ofthe cost of defending such a matter in court, the Company did offer asettlement. Several proposals have been made by the technology provider and theCompany. The Company now believes that a settlement is probable, although the usefullife over which a settlement would be recognized are uncertain. The Companyrecorded an accrual as of September 30, 2004

 

9

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for the low end of thesettlement range, to be amortized over the estimated useful life. The Companycannot provide assurance as to the outcome.

 

In 2002, theCompany received a letter from one of its resellers requesting indemnificationrelated to a request that the reseller had received for indemnification from acustomer. The customer had received a letter from a third party indicating thatthe customer may be infringing patents held by the third party. To date, theCompany’s patent counsel has not determined the validity or the applicabilityof these patents as they relate to the Company’s products or whether thereseller is entitled to indemnification. The Company believes that this mattercan be resolved without a material adverse effect on its business, financialcondition or results of operations; however, the Company cannot provideassurance as to the outcome.

 

On September30, 2003, Recursion Software, Inc. filed suit in Dallas County Court in Dallas,Texas against the Company alleging breach of contract and money due underclaims of quantum meruit, unjust enrichment and infringement. Recursion claimsthat the Company incorporated Recursion software into one of its products inbreach of the underlying license. The Company had the case removed to FederalDistrict Court in Dallas, Texas and Recursion has since asserted a copyrightinfringement claim. No dollar amount has been stated in the action. The Companybelieves that it has strong defenses to the claims and intends to vigorouslydefend against the action. The Company believes that this matter can beresolved without a material adverse effect on its business, financial conditionor results of operations; however, the Company cannot provide assurance as tothe outcome.

 

In 2002, theCompany received a notification from the French government as a result of a taxaudit that had been conducted encompassing the years 1998, 1999, 2000 and 2001.These assessments claim various taxes are owed related to Value Added Tax (VAT)and corporation taxes in addition to what has previously been paid and accrued.As of September 30, 2004, the assessment related to VAT was approximately $2.9million and the assessment related to corporation taxes was approximately$372,000. The Company’s tax counsel has assessed the possibility of the Companypaying the assessment related to VAT as remote and the assessment related tocorporation taxes as reasonably possible; the Company has not accrued for theseamounts. The Company is appealing the assessments, but cannot assure you thatthese matters will be resolved without litigation or that it will not have topay some or all of the assessments.

 

# **6.     Restructuring Charges**

 

In February2003, the Company announced its plan to downsize and reorganize resources inEMEA. The French office was significantly affected, with most positions movedor eliminated. The Company determined that the severance payments and relatedlegal fees incurred qualified as restructuring costs in accordance with FASBStatement No. 146, *Accounting for CostsAssociated with Exit or Disposal Activities*.

 

The Companyhas ten former employees from its French office with whom it has not reachedagreement regarding severance. The Company has recorded a liability for theestimated severance for those employees in accordance with FASB Statement No.146. The Company could incur additional expenses related to these employees forlegal fees and for additional severance costs when a settlement is reached.

 

EffectiveApril 1, 2003, the Company moved its worldwide headquarters to a new buildingin Indianapolis, Indiana and all Indianapolis-based employees, equipment andfurniture were relocated to the new facility. The majority of the lease on theprevious headquarters has expired, however the Company continues to owe leasepayments on a small portion of the previous headquarters through February 12,2005. The Company determined that the remaining lease payments as of April 1,2003 for the previous headquarters, net of sublease income, qualified as anexit cost and was recognized in accordance with SFAS 146 as restructuringcharges. The Company does not anticipate additional restructuring chargesrelated to the relocation of its worldwide headquarters.

 

10

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The Companyrecognized restructuring charges in accordance with FASB Statement No. 146 of$34,000 for the three months ended September 30, 2003 and $101,000 and $3.2million for the nine months ended September 30, 2004 and 2003, respectively.  The Company did not recognize anyrestructuring charges for the three months ended September 30, 2004.

 

A summary ofthe beginning accrued restructuring charges, expensed amount, cash payments andthe ending accrued restructuring charges for the nine months ended September30, 2004 is presented below (inthousands).

 
| ** **         | ** ** | **Beginning  Balance** | ** ** | **Expense** | ** ** | **Cash  Payments** | ** ** | **Ending  Balance** | ** ** |
|--------------------|------------|------------------------|------------|-------------|------------|--------------------|------------|---------------------|------------|
|               |       |                   |       |        |       |               |       |                |       |
| EMEA restructuring |       | $                      | 549        |        | $          | 101                |       | $                   | (207       | ) | $ | 443 |   |
| Headquarters       |       | 267                    |       | —      |       | (267               | )          | —              |       |
| Total              |       | $                      | 816        |        | $          | 101                |       | $                   | (474       | ) | $ | 443 |   |

 

# **Item 2. Management’sDiscussion and Analysis of Financial Condition**and Results of Operations

 

### **Forward-LookingInformation**

 

Certain statements in this Form 10-Q contain “forward-looking”information (as defined in Section 27A of the Securities Act of 1933, asamended and Section 21E of the Securities Exchange Act of 1934, asamended) that involve risks and uncertainties which may cause actual results todiffer materially from those predicted in the forward-looking statements.Forward-looking statements can often be identified by their use of such verbsas “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 “Certain factors that may affectour future operating results” described herein and the Risk Factors describedin our Securities and Exchange Commission filings, including the Form 10-Kfiling for the year ended December 31, 2003.

 

### **Overview**

 

We are aleading provider of software applications for contact centers and hope toleverage that leadership position to provide mission critical VoIP applicationsto enterprises. Our customers are in a wide variety of fields includingfinancial institutions, government, healthcare and retail, among others. We area global software provider with presence in: the Americas; Europe, Middle Eastand Africa (EMEA); and Australia and other Asia/Pacific countries (APAC).

 

### **Financial Highlights**

 

In the initialyears after we began licensing our software applications, our revenue growthwas substantial. In 2002 and 2003 we experienced the impact of a decrease inworldwide spending on technology, and as a result our revenue growthdiminished.  We believe that during theeconomic downturn and resulting decrease in technology spending, it becameharder to market our products to new customers. Companies delayed changes totheir systems and continued to use technology that they had in place. However,we believe that once companies have implemented our software and the personnelat these companies experience the capabilities and efficiencies of oursoftware, these companies are increasing their technology spending for oursoftware. Future licensing to new customers is dependent on the economy andwhether companies will allocate their resources to upgrade their systems.

 

Revenuesrecognized in the three months ended September 30, 2004 increased $1.3 millionfrom revenues for the three months ended September 30, 2003. Total revenues forthe nine months ended September 30, 2004 increased $2.1 million over the ninemonths ended September 30, 2003. Software

 

11

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revenues of $6.6 million forthe three months ended September 30, 2004 were up $900,000 over the threemonths ended September 30, 2003. Beginning in the first quarter of 2004, webegan offering perpetual licenses to our new customers and therefore therecognition of revenues on new contracts signed in 2004 was acceleratedcompared to how revenues were recognized under annually renewable licenses in2003.

 

Althoughrevenues have grown compared to last year at this time, growth in revenues hasbeen inconsistent during 2004 when compared to the previous quarter. Theinformation below shows our total revenues and percentage growth from theprevious two years and for the most recent four quarters (revenues inmillions).

 
| **Period**              | ** ** | **Revenues** | ** ** | **% Growth** | ** ** |
|-------------------------|------------|--------------|------------|--------------|------------|
| Three months ended:     |       |         |       |         |       |
| September 30, 2004      |       | $            | 13.4       |         | (2         | )% |
| June 30, 2004           |       | 13.6         |       | —       |       |
| March 31, 2004          |       | 13.7         |       | 6            |       |
| December 31, 2003       |       | 12.9         |       | 6            |       |
|                    |       |         |       |         |       |
| Year ended December 31: |       |         |       |         |       |
| 2003                    |       | 51.5         |       | 8            |       |
| 2002                    |       | 47.8         |       | —       |       |
|                         |            |              |            |              |            |  |

 

Operatingexpenses for the three months ended September 30, 2004 increased $356,000compared to the three months ended September 30, 2003. This increase was theresult of an increase in sales and marketing expenses due to set up costs forour newly formed subsidiary, Vonexus, and an increase in general andadministrative expenses due to increasing headcount and higher legal costs.This was offset by a decrease in research and development due to a reduction ofdepreciation.

 

We hadapproximately $15.6 million of cash and cash equivalents as of September 30,2004. We had borrowings under a line of credit of $2.0 million as of September30, 2004, which has since been repaid in full. We believe that as our revenuesgrow, our accounts receivable are collected timely and our expenses remaincontrolled, we will maintain or increase our liquidity position. If revenuesdecrease, or if we are unable to collect our account receivable balances fromour customers on a timely basis, our liquidity position may weaken, which wouldresult in the need to raise capital, either through the capital markets or debtfinancings.

 

We formed anew subsidiary, Vonexus, on July 1, 2004. Vonexus will be focused on selling acomplete IP-based phone system, including hardware, to Microsoft-based smalland medium-sized businesses. As a result of this new market focus, weexperienced higher expenses in sales and marketing in the third quarter of2004. We expect this higher cost to continue and expect to increase expensesslightly more in the fourth quarter. We expect to record revenues in the fourthquarter from Vonexus which will offset some of these additional expenses. Wemay also incur additional costs of revenues related to hardware costs and, as aconsequence, if Vonexus sales become significant our gross profits as apercentage of revenues may decline.

 

12

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**HistoricalResults of Operations**

 

The followingtable presents certain financial data, derived from our unaudited statements ofoperations, as a percentage of total revenues for the periods indicated. Theoperating results for the three and nine months ended September 30, 2004 and2003 are not necessarily indicative of the results that may be expected for thefull year or for any future period.

 
| ** **                        | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-----------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **                        | ** ** | **2004**                              | ** ** | **2003**                             | ** ** | **2004** | ** ** | **2003** | ** ** |
| Revenues:                         |       |                                  |       |                                 |       |   |   |   |   |
| Software                          |       | 49                                    | %          | 47                                   | %          | 51 | % | 52 | % |
| Services                          |       | 51                                    |       | 53                                   |       | 49 |   | 48 |   |
| Total revenues                    |       | 100                                   |       | 100                                  |       | 100 |   | 100 |   |
| Cost of revenues:                 |       |                                  |       |                                 |       |   |   |   |   |
| Software                          |       | 3                                     |       | 2                                    |       | 3 |   | 2 |   |
| Services                          |       | 19                                    |       | 24                                   |       | 20 |   | 25 |   |
| Total cost of revenues            |       | 22                                    |       | 26                                   |       | 23 |   | 27 |   |
| Gross profit                      |       | 78                                    |       | 74                                   |       | 77 |   | 73 |   |
| Operating expenses:               |       |                                  |       |                                 |       |   |   |   |   |
| Sales and marketing               |       | 40                                    |       | 42                                   |       | 39 |   | 39 |   |
| Research and development          |       | 24                                    |       | 27                                   |       | 24 |   | 27 |   |
| General and administrative        |       | 13                                    |       | 13                                   |       | 13 |   | 11 |   |
| Restructuring and other charges   |       | —                                |       | —                               |       | — |   | 8 |   |
| Total operating expenses          |       | 77                                    |       | 82                                   |       | 76 |   | 85 |   |
| Operating income (loss)           |       | 1                                     |       | (8                                   | )          | 1 |   | (12 | ) |
| Interest income, net              |       | —                                |       | —                               |       | — |   | — |   |
| Income (loss) before income taxes |       | 1                                     |       | (8                                   | )          | 1 |   | (12 | ) |
| Income taxes                      |       | —                                |       | —                               |       | — |   | — |   |
| Net income (loss)                 |       | 1                                     | %          | (8                                   | )%         | 1 | % | (12 | )% |

 

**Comparison of Three and Nine Months EndedSeptember 30, 2004 and 2003**

*** ***

***Revenues***

* *

*Software Revenues*

* *
| ** **                   | ** ** | **Three Months Ended  September 30,** |       | **Nine Months Ended  September 30,** |       |
|------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **                   | ** ** | **2004**                              | ** ** | **2003**                             | ** ** | **2004** | ** ** | **2003** |   |
| ** **                   |       | **($ in  thousands)**            |       |
| Software revenues            |       | $                                     | 6,591      |                                 | $          | 5,684 |   | $ | 20,841 |   | $ | 20,077 |   |
| Change from prior year       |       | 16                                    | %          | (16                                  | )%         | 4 | % | (9 | )% |
| Percentage of total revenues |       | 49                                    | %          | 47                                   | %          | 51 | % | 52 | % |
|                              |            |                                       |            |                                      |            |  |  |  |  |  |  |  |  |

 

The increasein software revenues and percent of software revenues to total revenues for thethree months ended September 30, 2004 compared to the three months ended September30, 2003, was related primarily to an increase in the percentage of perpetuallicense agreements we recognized in 2004. Beginning in the first quarter of2004, we began offering perpetual licenses to our new customers and thereforethe recognition of revenues on new contracts signed in 2004 was acceleratedcompared to how revenues were recognized under annually renewable licenses in2003. Customers prefer a perpetual license and the decision to offer customersperpetual licenses was a part of other actions designed to improve our customerlicensing process. Fifty percent of the software revenues recognized in thethree months ended September 30, 2004 were related to perpetual licenseagreements compared to 9% of the software revenues in the three months endedSeptember 30, 2003.

 

13

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Entering intomore perpetual license agreements had a similar effect on software revenues forthe nine months ended September 30, 2004 compared to software revenues for thenine months ended September 30, 2003. However, we recognized approximately $3million of software revenues in the first three months of 2003 related to aperpetual license agreement with one customer. Forty-four percent of thesoftware revenues recognized in the nine months ended September 30, 2004 wererelated to perpetual license agreements compared to 18% of the softwarerevenues in the nine months ended September 30, 2003 (including the one largeperpetual agreement during the first three months of 2003).

 

## *Services Revenues*

** **
| ** **                   | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **                   | ** ** | **2004**                              | ** ** | **2003**                             | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                   |       | **($ in  thousands)**            |       |
| Services revenues            |       | $                                     | 6,823      |                                 | $          | 6,455 |   | $ | 19,920 |   | $ | 18,553 |   |
| Change from prior year       |       | 6                                     | %          | 25                                   | %          | 7 | % | 33 | % |
| Percentage of total revenues |       | 51                                    | %          | 53                                   | %          | 49 | % | 48 | % |
|                              |            |                                       |            |                                      |            |  |  |  |  |  |  |  |  |

 

Servicesrevenues increased for the three and nine months ended September 30, 2004compared to the three and nine months ended September 30, 2003.  These increases were primarily due toincreases in our growing installed base of customers and related payments ofannual license renewal fees and ongoing maintenance from perpetual licenses. Ourservices revenues should grow as we sign and install new customers and as existingcustomers continue to renew licenses and pay for maintenance on our softwareapplications. In addition, cash collection of services receivables improvedduring the three months ended September 30, 2004, which resulted in moreservices revenues being recognized. The percent of services revenues to totalrevenues remained relatively constant.

##### *** ***

##### ***Cost of Revenues***

** **
| ** **                                 | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|--------------------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **                                 | ** ** | **2004**                              | ** ** | **2003**                             | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                 | ** ** | **($ in  thousands)**            | ** ** |
| ** **                                 | ** ** | ** **                            | ** ** | ** **                           | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cost of revenues:                          |       |                                  |       |                                 |       |   |   |   |   |
| Software                                   |       | $                                     | 446        |                                 | $          | 254 |   | $ | 1,339 |   | $ | 871 |   |
| Services                                   |       | 2,570                                 |       | 2,962                                |       | 8,200 |   | 9,402 |   |
| Total cost of revenues                     |       | $                                     | 3,016      |                                 | $          | 3,216 |   | $ | 9,539 |   | $ | 10,273 |   |
| Change from prior year                     |       | (6                                    | )%         | 1                                    | %          | (7 | )% | 8 | % |
| Software costs as a % of software revenues |       | 7                                     | %          | 4                                    | %          | 6 | % | 4 | % |
| Services costs as a % of services revenues |       | 38                                    | %          | 46                                   | %          | 41 | % | 51 | % |

 

Costs ofsoftware consist primarily of product and software royalties paid to thirdparties for the use of their technologies in our products and, to a lesserextent, software packaging costs, which include product media, duplication anddocumentation. Costs of software can fluctuate depending on which softwareapplications are licensed to our customers, and the third party technology, ifany, which is licensed. The increase in the software costs for the three andnine months ended September 30, 2004 compared to the three and nine monthsended September 30, 2003 was due to increased royalties for third partysoftware.

 

Costs ofservices consist primarily of compensation expenses for technical support,education and professional services personnel and other costs associated withsupporting our resellers and customers. The decrease in costs of services andcosts of services as a percent of services revenues for the three and ninemonths ended September 30, 2004 compared to September 30, 2003 was a result ofour focus on cost control (which resulted in a decrease in staffing in thisarea), a reduction in depreciation, as well as a reduction in our utilizationof outside sources to provide professional services for our customers.

 

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##### ***Gross Profit***

 
| ** **                   | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **                   | ** ** | **2004**                              | ** ** | **2003**                             | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                   | ** ** | **($ in thousands)**             | ** ** |
| Gross profit                 |       | $                                     | 10,398     |                                 | $          | 8,923 |   | $ | 31,222 |   | $ | 28,357 |   |
| Change from prior year       |       | 17                                    | %          | 2                                    | %          | 10 | % | 7 | % |
| Percentage of total revenues |       | 78                                    | %          | 74                                   | %          | 77 | % | 73 | % |
|                              |            |                                       |            |                                      |            |  |  |  |  |  |  |  |  |

 

Gross profitand gross profit as a percentage of total revenues increased for the three andnine months ended September 30, 2004 compared to September 30, 2003. This increasewas the result of an increase in total revenues resulting from more perpetuallicense agreements and our growing customer base and a decrease in cost ofservices due to a reduction in staffing, depreciation and outside services.

 

##### ***Operating Expenses***

##  

## *Sales and Marketing*

** **
| ** **                      | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|---------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **                      | ** ** | **2004**                              | ** ** | **2003**                             | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                      | ** ** | **($ in thousands)**             | ** ** |
| Sales and marketing expenses    |       | $                                     | 5,301      |                                 | $          | 5,028 |   | $ | 15,405 |   | $ | 15,145 |   |
| Change from prior year          |       | 5                                     | %          | (3                                   | )%         | 2 | % | (5 | )% |
| Percentage of total revenues    |       | 40                                    | %          | 42                                   | %          | 39 | % | 39 | % |
| Percentage of software revenues |       | 80                                    | %          | 88                                   | %          | 74 | % | 75 | % |
|                                 |            |                                       |            |                                      |            |  |  |  |  |  |  |  |  |

 

Sales andmarketing expenses are comprised primarily of compensation expense and travel,entertainment and other related expenses and increased for the three and ninemonths ended September 30, 2004 compared to September 30, 2003. As anticipatedand discussed in the second quarter Form 10-Q filing, this increase was due to payrollexpenses and other costs associated with the launch of Vonexus of approximately$350,000. As described previously under Financial Highlights, we expect theseVonexus costs to continue and increase slightly in the fourth quarter of 2004,although we expect to record some revenues from Vonexus in the fourth quarter tooffset some of the increased expenses.

 

## *Research andDevelopment*

 
| ** **                        | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-----------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **                        | ** ** | **2004**                              | ** ** | **2003**                             | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                        | ** ** | **($ in thousands)**             | ** ** |
| Research and development expenses |       | $                                     | 3,208      |                                 | $          | 3,322 |   | $ | 9,744 |   | $ | 10,289 |   |
| Change from prior year            |       | (3                                    | )%         | (11                                  | )%         | (5 | )% | (9 | )% |
| Percentage of total revenues      |       | 24                                    | %          | 27                                   | %          | 24 | % | 27 | % |
|                                   |            |                                       |            |                                      |            |  |  |  |  |  |  |  |  |

 

Research anddevelopment expenses are comprised primarily of compensation expenses.  Research and development expenses decreasedfor the three and nine months ended September 30, 2004 compared to September30, 2003 due to a decrease in staffing and lower depreciation expense as someof our assets become fully depreciated.

 

15

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## *General andAdministrative*

** **
| ** **                          | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-------------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **                          | ** ** | **2004**                              | ** ** | **2003**                             | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                          | ** ** | **($ in thousands)**             | ** ** |
| General and administrative expenses |       | $                                     | 1,777      |                                 | $          | 1,546 |   | $ | 5,370 |   | $ | 4,358 |   |
| Change from prior year              |       | 15                                    | %          | 13                                   | %          | 23 | % | 3 | % |
| Percentage of total revenues        |       | 13                                    | %          | 13                                   | %          | 13 | % | 11 | % |
|                                     |            |                                       |            |                                      |            |  |  |  |  |  |  |  |  |

 

General andadministrative expenses are comprised of compensation expense and non-allocableexpenses including bad debt, legal and other professional service fees. Generaland administrative expenses increased for the three and nine months endedSeptember 30, 2004 compared to September 30, 2003. This increase was the resultof higher payroll expenses, as a result of increased staffing, and an increasein premiums for corporate insurance partially offset by a decrease indepreciation. Outside legal expenses increased significantly due to increased costsrelated to litigation and other claims against the Company. See Note 5 of Notesto Condensed Consolidated Financial Statements for a description of legalmatters.

 

## *Restructuring andOther Charges*

 
| ** **                      | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|---------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **                      | ** ** | **2004**                              | ** ** | **2003**                             | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                      | ** ** | **($ in thousands)**             | ** ** |
| Restructuring and other charges |       | $                                     | —     |                                 | $          | 34 |   | $ | 101 |   | $ | 3,172 |   |
| Change from prior year          |       | (100                                  | )%         | 100                                  | %          | (97 | )% | 365 | % |
| Percentage of total revenues    |       | 0                                     | %          | 0                                    | %          | 0 | % | 8 | % |
|                                 |            |                                       |            |                                      |            |  |  |  |  |  |  |  |  |

 

Restructuringand other charges decreased significantly for the nine months ended September30, 2004 compared to September 30, 2003. During the second quarter of 2003, weincurred $2.7 million in charges related to the restructuring of our Europeanoperations and relocation of our worldwide headquarters. In February 2003, weannounced our plan to downsize and reorganize our resources in EMEA. The Frenchoffice was most affected with most of the French employees terminated orrelocated. We recognized these expenses in accordance with FASB Statement No.146, *Accounting for Costs Associated with Exit orDisposal Activities* (SFAS 146). The restructuring and other expensesrecognized in the nine months ended September 30, 2004 were legal fees incurredduring the period related to the EMEA reorganization. We expect to incur someadditional expenses related to the restructuring of international operations infuture periods; however, at this time, we do not expect the amount to besignificant. See Note 6 of Notes to Condensed Consolidated FinancialStatements. Although we do not currently believe that we will need to furtherreduce staff, the state of the economy and resulting technology spending bybusinesses, among other factors, could result in further reductions.

 

We moved ourworldwide headquarters to a new building in Indianapolis, Indiana effectiveApril 1, 2003. Because we continued to owe lease payments on the previousheadquarters, we determined that those lease payments, net of sublease income,qualified as exit costs in accordance with SFAS 146. We recognized a total of$1.6 million of restructuring and other charges in the second quarter of 2003related to this relocation.

##### *** ***

##### ***Interest Income, Net***

 

The majorityof interest income, net is made up of interest earned from investments andinterest-bearing cash accounts. Interest expense, which is not material for anyperiods reported, is also included in interest income, net. We have experienceddecreased interest earnings in 2004 as compared to 2003 as shown below.

 

16

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| ** **                            | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|---------------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **                            | ** ** | **2004**                              | ** ** | **2003**                             | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                            | ** ** | **($ in thousands)**             | ** ** |
| Cash, cash equivalents and short-term |       |                                  |       |                                 |       |   |   |   |   |
| investments (average)                 |       | $                                     | 15,326     |                                 | $          | 15,119 |   | $ | 15,558 |   | $ | 15,169 |   |
| Interest income                       |       | 31                                    |       | 38                                   |       | 78 |   | 145 |   |
| Return on investment (annual)         |       | 0.8                                   | %          | 1.0                                  | %          | 0.7 | % | 1.3 | % |
|                                       |            |                                       |            |                                      |            |  |  |  |  |  |  |  |  |

 

The decreasein net interest income for the three and nine months ended September 30, 2004compared to September 30, 2003 was related mainly to a decrease in interestrates and to the mix of investments. In 2003, we utilized short-terminvestments in our investing strategy, while in 2004, all cash was held in cashand cash equivalents accounts. Cash and cash equivalents earn a lower rate ofreturn than short-term investments. We opted to invest in this more liquid mixof investments in 2004 in order to ensure the availability of our cash.

 

### **Liquidity andCapital Resources**

 

In 1999 weraised cash through an initial public offering that provided net proceeds of$34.9 million. In 2001 we received an equity investment that yielded $15million in cash. In addition, we generate cash from the collections we receiverelated to licensing our application software and from annual license renewals,maintenance and support and other services revenues. We also have in place a $3million line of credit, of which we had utilized $2 million as of September 30,2004, all of which was repaid in full subsequent to September 30, 2004. We usecash primarily for paying our employees (including salaries, commissions,benefits and severance), leasing office space, reimbursing travel expenses,paying insurance premiums and paying vendors for services rendered and suppliespurchased. In addition, we purchase property and equipment, includingfurnishing our new worldwide headquarters and in-house technologypurchases.  We also used cash during thethird quarter of 2004 to start up a new wholly-owned subsidiary, Vonexus.

 

We determineliquidity by combining cash and cash equivalents and short-term investments netof our line of credit borrowings as shown in the table below. Our totalliquidity position improved as of September 30, 2004 compared with our positionas of December 31, 2003. In general this improvement was due to the timing ofour accounts receivable collections. We believe that our current liquidityposition, when combined with our anticipated cash flows from operations, willbe sufficient to satisfy our cash needs over the next 12 months. If cash flowsfrom operations are less than anticipated or we have additional cash needs(such as an unfavorable outcome in legal proceedings), our liquidity may not besufficient to cover our needs. In this case, we may be forced to raiseadditional capital, either through the capital markets or debt financings. Wemay not be able to receive favorable terms in raising this capital.

 
| ** **                | ** ** | **September 30,  2004**   | ** ** | **December 31,  2003** | ** ** |
|---------------------------|------------|---------------------------|------------|------------------------|------------|
| ** **                | ** ** | **($ in thousands)** | ** ** |
| Cash and cash equivalents |       | $                         | 15,646     |                   | $          | 12,461 |   |
| Short-term investments    |       | —                    |       | 3,008                  |       |
| Line of credit            |       | (2,000                    | )          | (2,800                 | )          |
| Liquidity, net            |       | $                         | 13,646     |                   | $          | 12,669 |   |

 

Our operating activitiesresulted in net cash provided of $1.7 million for the nine months endedSeptember 30, 2004 compared with net cash provided of $2.2 million for the ninemonths ended September 30, 2003. These cash results from our operatingactivities were affected by fluctuations in accounts receivable (the balancedecreased $2.5 million and $1.9 million for the nine months ended September 30,2004 and September 30, 2003, respectively), prepaid expenses (the balancedecreased by $245,000 for the nine months ended September 30, 2004 compared toa decrease of $706,000 for the nine months ended September 30, 2003), accountspayable (the balance increased $1.0 million and $1.5 million for the nine

 

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months ended September 30, 2004and September 30, 2003, respectively) and deferred revenues (which decreased$4.4 million for the nine months ended September 30, 2004 compared to adecrease of $1.3 million for the nine months ended September 30, 2003).

 

The amountthat we report as cash and cash equivalents or as temporary investmentsfluctuates depending on investing practices in each period. Purchases ofshort-term investments are reported as a use of cash and the related receipt ofproceeds upon maturity of the investment is reported as a source of cash.

 

We purchasedproperty and equipment with a cost of $1.1 million and $2.7 million in the ninemonths ended September 30, 2004 and 2003, respectively. We moved our worldwideheadquarters in the second quarter of 2003 and purchased certain property andequipment in connection with that move.

 

The netdecrease in our borrowings on our line of credit used cash of $800,000 for thenine months ended September 30, 2004.

 

### **Critical AccountingPolicies and Estimates**

 

We believethere are three accounting policies that are important to understanding ourhistorical and future performance, as these policies affect the reportedamounts of revenues and expenses and are the more significant areas involvingmanagement’s judgments and estimates. These critical accounting policies andestimates relate to revenue recognition, the allowance for doubtful accountsreceivable and research and development. These policies, and our proceduresrelated to these policies, are described below.

##### *** ***

##### ***Sources of Revenues and Revenue RecognitionPolicy***

 

We generatesoftware revenues from licensing the right to use our software applications andgenerate services revenues primarily from annual renewal fees, annualmaintenance fees, educational services and professional services. We believeboth of these sources of revenues are critical to our financial statementsbecause of their materiality to our statements as a whole and because of thejudgment required in determining if revenue recognition criteria have been met.

 

## *Software Revenues*

 

Our softwarelicense agreements are either annually renewable or perpetual. For any revenuesto be recognized from a software license agreement, the following criteria mustbe met:

•                  persuasiveevidence of an arrangement exists;

•                  the fee is fixedor determinable;

•                  collection isprobable; and

•                  delivery hasoccurred.

 

For anannually renewable software license agreement, upon meeting the revenuerecognition criteria above, we recognize a majority of the initial license feesunder these agreements as software revenues ratably over the initial licenseperiod, which is generally 12 months, and the remainder of the initial licensefees are recognized as services revenues over the same time period.

 

For aperpetual software license agreement, upon meeting the revenue recognitioncriteria above, we immediately recognize as software revenues the amount ofinitial license fees 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 the fairvalue of the undelivered elements does not exist, we recognize the initiallicense fee as software revenues ratably over the initial term of themaintenance agreement, which is generally 12 months.

 

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## *Services Revenues*

 

Servicesrevenues are recognized for annually renewable software license agreements andperpetual software license agreements. For annually renewable software licenseagreements, the allocation of the initial order between software revenues andservices revenues is based on an average of actual renewal fee rates. After theinitial license period, our customers may renew their license agreement for anadditional period, typically 12 months, by paying a renewal fee. Underperpetual software license agreements, we recognize initial annual maintenancefees based on actual renewal fee rates as services revenues ratably over thepost-contract maintenance period, which is typically 12 months beginning at thedate support is deemed to commence.

 

We alsogenerate services revenues from other services that we provide to our resellersand customers. These additional services revenues include fees for educationalservices and professional services. Revenues from educational services, whichconsist of training courses for resellers and customers, and professionalservices, which include implementing and customizing our products for acustomer, are typically recognized as the related services are performed.

 

##### ***Allowance for Doubtful Accounts Receivable***

 

We adjust ourallowance for doubtful accounts for each reporting period based on a detailedanalysis of our accounts receivable at the end of that period. In estimatingthe allowance for doubtful accounts, we primarily consider the age of thereseller’s or customer’s receivable and also consider the creditworthiness ofthe reseller or customer, the economic conditions of the customer’s industry,and general economic conditions, among other factors. If payment is not madetimely, we contact the customer or reseller to try to obtain payment. If thisis not successful, we institute other collection practices such as generatingcollection letters, involving our sales representatives, involving a thirdparty collection agency and ultimately terminating the customer’s license(s)and/or the customer’s and reseller’s access to future upgrades, licenses andcustomer support. Once all collection efforts are exhausted, the receivable iswritten off against the allowance for doubtful accounts.

##### *** ***

##### ***Research and Development***

 

Research anddevelopment expenditures are generally expensed as incurred. Based on ourproduct development process and technological feasibility, the date at whichcapitalization of development costs may begin is established upon completion ofa working model. Costs incurred between completion of the working model and thepoint at which the product is ready for general release have beeninsignificant. Through September 30, 2004, all research and development costshave been expensed.

 

# **Certainfactors that may affect our future operating results are set forth below:**

# ** **

# **THEOVERALL ECONOMIC CLIMATE MAY BE WEAK**

# ** **

Our productstypically represent substantial capital commitments by customers and involve apotentially long sales cycle. As a result, customer purchase decisions may besignificantly affected by a variety of factors, including general economictrends in the allocation of capital spending budgets to communication software,services and systems, lengthened sales cycles, customer approval processes, andmarket conditions, which have resulted in many of our customers delaying and/orreducing their capital spending related to information systems. If the economyis weak, demand for our products could decrease, resulting in lower revenues.

 

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

 

Sinceinception, we have incurred substantial losses, however, in 2004 we have beenprofitable. We had net income of $526,000 in the nine months ended September30, 2004 and net losses of $5.9 million

 

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and $7.7 million for theyears ended December 31, 2003 and 2002, respectively. At September 30, 2004, wehad accumulated net losses since inception of $60.8 million. We intend tocontinue to make significant investments in our research and development,marketing, services and sales operations. Certain of these expenses willprecede generation of revenues. As a result, we may continue to experiencelosses and/or negative cash flow from operations in future quarters.

 

# **OURQUARTERLY OPERATING RESULTS HAVE VARIED SIGNIFICANTLY**

 

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

 

Because we donot know if or when our potential customers will place orders and finalizelicenses, and because it is difficult to predict the mix of annually renewablelicenses and perpetual licenses in a quarter, we cannot accurately forecast ourlicensing activity, our revenues and our operating results for future quarters.We recognize revenues from different licenses over different periods dependingon the satisfaction of the requirements of relevant accounting literature,including AICPA Statement of Position 97-2, Statement of Position 98-9, SECStaff Accounting Bulletin (SAB) 104, and all related AICPA Technical PracticeAids (5100.38 - 5100.76). As a result, our quarterly revenues andoperating results depend on many factors, including the type of license, thesize, quantity and timing of orders received for our products during eachquarter, the delivery of the related software and our expectations regardingcollection. If a large number of orders or several large orders do not occur orare deferred or delayed, our revenues in a quarter could be substantiallyreduced. This risk is heightened by the significant investment and executivelevel decision-making typically involved in our customers’ decisions to licenseour products. Since a large portion of our operating expenses, includingsalaries and rent, is fixed and difficult to reduce or modify in a short timeperiod, our business, financial condition or results of operations could bematerially adversely affected if revenues do not meet our expectations.

 

Our limitednumber of products, changes in pricing policies, the timing of developmentcompletion, and announcement and sale of new or upgraded versions of ourproducts are some of the additional factors that could cause our revenues andoperating results to vary significantly from quarter to quarter.

 

# **WEHAVE A LENGTHY PRODUCT SALES CYCLE WHICH HAS CONTRIBUTED AND MAY CONTINUE TOCONTRIBUTE TO THE VARIABILITY OF QUARTERLY OPERATING RESULTS**

 

We havegenerally 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. The lengthy sales cycle also makesit difficult for us to forecast product license revenues. Because of the uniquecharacteristics of our products, our prospective customers’ decisions tolicense our products often require significant investment and executive-leveldecision making. We believe that many companies currently are not aware of thebenefits of interaction management software of the type that we license or ofour products and capabilities. For this reason, we must provide a significantlevel of education to prospective customers about the use and benefits of ourproducts, which can cause potential customers to take many months to make thesedecisions. As a result, sales cycles for customer orders vary substantiallyfrom customer to customer. Excessive delay in product sales could materiallyadversely affect our business, financial condition or results of operations.

 

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The length ofthe sales cycle for customer orders depends on a number of other factors overwhich we have little or no control, including:

•                  a customer’sbudgetary constraints;

•                  the timing of acustomer’s budget cycles;

•                  concerns bycustomers about the introduction of new products by us or our competitors; and

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

 

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

 

# **OURINABILITY TO SUCCESSFULLY MANAGE 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 have 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**

 

The market forour software applications is highly competitive and, because there arerelatively low barriers to entry in the software market, we expect competitionto increase in the future. In addition, because our industry is evolving andcharacterized by rapid technological change, it is difficult for us to predictwhether, when and by whom new competing technologies or new competitors may beintroduced into our markets. Currently, our competition comes from severaldifferent market segments, including computer telephony platform developers,computer telephony applications software developers and telecommunicationsequipment vendors. We cannot assure you that we will be able to competeeffectively against current and future competitors. In addition, increasedcompetition or other competitive pressures may result in price reductions, reducedmargins or loss of market share, any of which could have a material adverseeffect on our business, financial condition or results of operations.

 

Many of ourcurrent and potential competitors have longer operating histories,significantly greater financial, technical, marketing, customer service andother resources, greater name recognition and a larger installed base ofcustomers than we do. As a result, these competitors may be able to respond tonew or emerging technologies and changes in customer requirements faster andmore effectively than we can, or to devote greater resources to thedevelopment, promotion and sale of products than we can. Current and potentialcompetitors have established, and may in the future establish, cooperativerelationships among themselves or with third parties, including mergers oracquisitions, to increase the ability of their products to address the needs ofour current or prospective customers. If these competitors were to acquiresignificant market share, it could have a material adverse effect on ourbusiness, financial condition or results of operations.

 

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# **WEMAY NOT BE ABLE TO GROW OUR BUSINESS IF WE DO NOT MAINTAIN SUCCESSFULRELATIONSHIPS WITH OUR RESELLERS AND OEM PARTNERS AND CONTINUE TO RECRUIT ANDDEVELOP ADDITIONAL SUCCESSFUL RESELLERS AND OEM PARTNERS**

 

Our ability toachieve revenue growth in the future will depend in part on our success inmaintaining successful relationships with our existing and future resellers andOEM partners and in recruiting and training additional resellers and OEMpartners. We rely primarily on resellers to market and support our products andplan on continuing to rely heavily on such partners in the future. We are stilldeveloping our reseller and OEM distribution networks and may be unable toattract additional resellers with both voice and data expertise or appropriateOEM partners that will be able to market our products effectively and that willbe qualified to provide timely and cost-effective customer support and service.We generally do not have long-term or exclusive agreements with our resellersor OEM partners, and the loss of specific larger resellers or OEM partners or asignificant number of resellers or OEM partners could materially adverselyaffect our business, financial condition or results of operations.

 

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

# ** **

The market forour products is characterized by rapid technological change, frequent newproduct introductions and enhancements, uncertain product life cycles andchanging customer demands. The introduction of products embodying newtechnologies and the emergence of new industry standards could render existingproducts obsolete or unmarketable and cause us to incur significant developmentcosts and prevent us from attracting new customers.

 

# **ADECLINE IN MARKET ACCEPTANCE FOR MICROSOFT TECHNOLOGIES ON WHICH OUR PRODUCTSRELY COULD HAVE A MATERIAL ADVERSE EFFECT ON US**

 

Our productscurrently run only on Microsoft Windows operating systems. In addition, ourproducts use other Microsoft technologies, including Microsoft Exchange Serverand Microsoft SQL Server. A decline in market acceptance for Microsofttechnologies or the increased acceptance of other server technologies couldcause us to incur significant development costs and could have a materialadverse effect on our ability to market our current products. Although webelieve that Microsoft technologies will continue to be widely used bybusinesses, we cannot assure you that businesses will adopt these technologiesas anticipated or will not in the future migrate to other computingtechnologies that we do not currently support. In addition, our products andtechnologies must continue to be compatible with new developments in Microsofttechnologies.

 

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

 

We believethat our future business prospects depend in large part on our ability tomaintain and improve our current software applications and to develop newsoftware applications on a timely basis. Our software applications will have tocontinue to achieve market acceptance, maintain technological competitivenessand meet an expanding range of customer requirements. As a result of thecomplexities inherent in our applications, major new applications andapplication enhancements require long development and testing periods. We maynot be successful in developing and marketing, on a timely and cost effectivebasis, application enhancements or new software applications that respond totechnological change, evolving industry standards or customer requirements. Wemay also experience difficulties that could delay or prevent the successfuldevelopment, introduction or marketing of application enhancements, and our newapplications and application enhancements may not achieve market acceptance.Significant delays in the general availability of new releases of our softwareapplications or significant problems in the

 

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installation or implementationof new releases of our applications 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 GROWTH PROSPECTS**

 

If the demandfor interaction management software of the type we license does not grow withineach of our four targeted markets, our financial results and ability to growour business could be materially adversely affected. All of our revenues havebeen generated from licenses of our Interaction Center Platform software orcomplementary 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 customers in significantlylarger numbers than we have historically achieved.

 

# **IFOUR CUSTOMERS DO NOT PERCEIVE OUR PRODUCTS OR THE RELATED SERVICES PROVIDED BYUS OR OUR RESELLERS OR OEM PARTNERS TO BE EFFECTIVE OR OF HIGH QUALITY, OURBRAND AND NAME RECOGNITION WILL SUFFER**

 

We believethat establishing and maintaining brand and name recognition is critical forattracting, retaining and expanding customers in our target markets. We alsobelieve that the importance of reputation and name recognition will increase ascompetition in our market increases. Promotion and enhancement of our name willdepend on the effectiveness of our marketing and advertising efforts and on oursuccess in providing high-quality products and related services, neither ofwhich can be assured. If our customers do not perceive our products or relatedservices to be effective or of high quality, our brand and name recognitionwould suffer which could have a material adverse effect on our business,financial condition or results of operations.

 

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

 

We regard oursoftware products as proprietary. In an effort to protect our proprietaryrights, we rely primarily on a combination of copyright, trademark and tradesecret laws, as well as patents, licensing and other agreements withconsultants, suppliers, strategic and OEM partners, resellers and customers,and employee and third-party non-disclosure agreements. These laws andagreements provide only limited protection of our proprietary rights. It may bepossible for a third party to copy or otherwise obtain and use our technologywithout authorization. A third party could also develop similar technologyindependently. In addition, the laws of some countries in which we sell ourproducts do not protect our software and intellectual property rights to thesame extent as the laws of the United States. Unauthorized copying, use or reverseengineering of our products could materially adversely affect our business,results of operations or financial condition.

 

We licensetechnology that is embedded in our products. If one or more of these licensesterminates or cannot be renewed on satisfactory terms, we would have to modifythe affected products to use alternative technology or eliminate the affectedproduct function, either of which could have a material adverse effect on us.

 

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# **INFRINGEMENTCLAIMS COULD ADVERSELY AFFECT US**

 

Third partieshave claimed or may in the future claim that our technology infringes theirproprietary rights. As the number of software products in our target marketsincreases and the functionality of these products overlap, we believe thatsoftware developers may face additional infringement claims. See Note 5 ofNotes to the Condensed Consolidated Financial Statements for a description ofcontingencies.

 

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

 

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

 

Our successdepends in large part on the continued service of our key personnel, particularlyDr. Donald E. Brown, our Chief Executive Officer and principalstockholder. The loss of the services of Dr. Donald E. Brown or other keypersonnel could have a material adverse effect on our business, financialcondition or results of operations. Our future success also depends on ourability to attract, train, assimilate and retain additional qualifiedpersonnel. Competition for persons with skills in the software industry isintense, particularly for those with relevant technical and/or sales experience.We cannot assure you that we will be able to retain our key employees or thatwe can attract, train, assimilate or retain other highly qualified personnel inthe future.

 

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

 

In the futurewe may pursue acquisitions to diversify our product offerings and customer baseor for other strategic purposes. We have no prior history of making materialacquisitions and we cannot assure you that any future acquisitions will besuccessful. The following are some of the risks associated with acquisitionsthat could have a material adverse effect on our business, financial conditionor 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 witha corporate 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.

•                  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 expense related tointangible assets recorded in future acquisitions.

•                  We may becompeting with other firms, many of which have greater financial and otherresources, to acquire attractive companies, making it more difficult to acquiresuitable companies on acceptable terms.

 

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# **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 21%, 13% and 19% of our total revenues for the nine months endedSeptember 30, 2004 and the years ended December 31, 2003 and 2002,respectively. We have marketing efforts in the Americas, EMEA and APAC. 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, other risks inherent in our international businessactivities may 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;

•                  acts ofterrorism; 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 customers located in countries whohave adopted the Euro as their official currency. Our international expensesare generally denominated in local foreign currencies. Although foreigncurrency translation gains and losses have been immaterial to date,fluctuations in exchange rates between the U.S. dollar and other currenciescould have a material adverse effect on our business, financial condition orresults of operations, and particularly on our operating margins. To date, wehave minimally sought to hedge the risks associated with fluctuations inexchange rates, but we may more actively undertake to do so in the future. Anyhedging techniques we implement in the future may not be successful. Exchangerate fluctuations could also make our products more expensive than competitiveproducts not subject to these fluctuations, which could adversely affect ourrevenues and profitability in international markets.

# ** **

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

 

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

 

Our licenseagreements with our customers typically contain provisions designed to limitour exposure to potential product liability and some contract claims. However,not all of these agreements contain these

 

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types of provisions and, wherepresent, these provisions vary as to their terms and may not be effective underthe laws of some jurisdictions. A product liability, warranty, or other claimbrought against us could have a material adverse effect on our business,financial condition or results of operations.

 

Performanceinterruptions in our products could also affect demand for our products or giverise to claims against us.

 

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

 

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

 

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

 

Our stockprice has been and could continue to be highly volatile due to a number offactors, including:

•                  actual oranticipated fluctuations in our operating results;

•                  announcements byus, our competitors or our customers;

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

•                  technologicalinnovations by others;

•                  the operatingand stock price performance of other comparable companies or of ourcompetitors;

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

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

•                  general marketor economic conditions.

 

This risk maybe heightened because our industry is new and evolving, characterized by rapidtechnological change and susceptible to the introduction of new competingtechnologies or competitors.

 

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

 

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

 

The variousmarkets operated by The NASDAQ Stock Market have quantitative maintenancecriteria for continued listing of common stock. We may be delisted from one ormore NASDAQ markets if we fail to comply with the criteria. While we believethat we currently meet criteria for listing on a market operated by The NASDAQStock Market, we can offer no assurance that our common stock will continue tomeet the various criteria for continued listing on any market operated by TheNASDAQ Stock Market. Any delisting may result in a reduction in the liquidityof our common stock, which may have a material adverse effect on the price ofour common stock.

 

# **REGULATORYCHANGES MADE TO ACCOUNTING PRINCIPLES GENERALLY ACCEPTED IN THE UNITED STATESOF AMERICA OR CORPORATE GOVERNANCE MATTERS MAY IMPACT OUR BUSINESS**

 

Revisions toaccounting principles generally accepted in the United States of America willrequire us to review our accounting and financial reporting procedures in orderto ensure continued compliance with required policies. From time to time, suchchanges may have a short-term impact on our reporting, and these changes may impactmarket perception of our financial condition. In addition, legislative changes,and the perception these changes create, can have a material, adverse effect onour business. For example:

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

•                  changes in thelegal climate may lead to additional liability concerns which may result inincreased insurance costs.

 

# **OUREXECUTIVE OFFICERS AND DIRECTORS CONTROL US AND MAY MAKE DECISIONS THATSHAREHOLDERS DO NOT CONSIDER TO BE IN THEIR BEST INTERESTS**

 

Our currentdirectors and executive officers together beneficially own more than 50% of ouroutstanding common stock. Accordingly, these shareholders are able to controlus through their ability to determine the outcome of the election of ourdirectors, amend our Restated Articles of Incorporation and By-Laws and takeother actions requiring the vote or consent of shareholders, including mergers,going private transactions and other extraordinary transactions, and the termsof any of these transactions. The ownership position of these shareholders mayhave the effect of delaying, deterring or preventing a change in control or achange in the composition of our board of directors.

 

# **ANTI-TAKEOVERPROVISIONS IN OUR ORGANIZATIONAL DOCUMENTS AND INDIANA LAW MAKE ANY CHANGE INCONTROL OF US MORE DIFFICULT, MAY DISCOURAGE BIDS AT A PREMIUM OVER THE MARKETPRICE AND MAY ADVERSELY AFFECT THE MARKET PRICE OF OUR STOCK**

 

Our RestatedArticles of Incorporation and By-Laws contain provisions that may have theeffect of delaying, deferring or preventing a change in control of us, maydiscourage bids at a premium over the market price of our common stock and mayadversely affect the market price of our common stock, and the voting and otherrights of the holders of our common stock. These provisions include:

•                  the division ofour board of directors into three classes serving staggered three-year terms;

•                  removal ofdirectors only for cause and only upon a 66 2/3% shareholder vote;

•                  prohibitingshareholders from calling a special meeting of shareholders;

•                  the ability toissue additional shares of our common stock or preferred stock withoutshareholders’ approval; and

•                  advance noticerequirements for raising business or making nominations at shareholders’meetings.

 

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The Indianacorporation law contains business combination provisions that, in general,prohibit for five years any business combination with a beneficial owner of 10%or more of our common stock unless the holder’s acquisition of the stock wasapproved in advance by our board of directors. The Indiana corporation law alsocontains control share acquisition provisions that limit the ability of certainshareholders to vote their shares unless their control share acquisition wasapproved in advance.

# ** **

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

 

The risks anduncertainties discussed above are in addition to those that apply to mostbusinesses generally. In addition, as we continue to grow our business, we mayencounter other risks of which we are not aware at this time. These additionalrisks may cause serious damage to our business in the future, the impact ofwhich we cannot estimate at this time.

 

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

 

We develop products in the United States and selllicenses in the Americas, EMEA and APAC. As a result, our financial resultscould be affected by various factors, including changes in foreign currencyexchange rates or weak economic conditions in foreign markets. As most salesare currently made in U.S. dollars, a strengthening of the dollar could makeour products less competitive in foreign markets. Additionally, as our businessmatures in foreign markets, we may offer our products and services in certainother local currencies. As a result, we will be subject to foreign currencyfluctuations which may have an adverse affect on our company.

 

We manage ourinterest rate risk by maintaining an investment portfolio with debt instrumentsof high credit quality and relatively short average maturities. We also manageinterest rate risk by maintaining sufficient cash and cash equivalent balancessuch that we are typically able to hold our investments to maturity. We have aline of credit with a variable interest rate based upon the bank’s prime rateon which we incur interest expense when the line is utilized.

 

**Item 4.Controls and Procedures**

 

We maintain aset of disclosure controls and procedures that are designed to ensure thatinformation required to be disclosed by us in the reports filed by us under theSecurities Exchange Act of 1934, as amended (Exchange Act) is recorded,processed, summarized and reported within the time periods specified in the SEC’srules and forms. We carried out an evaluation, under the supervision and withthe participation of our management, including our President and ChiefExecutive Officer and our Chief Financial Officer, of the effectiveness of thedesign and operation of our disclosure controls and procedures as of September 30,2004 pursuant to Rule 13a-15(b) of the Exchange Act. Based on that evaluation,our President and Chief Executive Officer and our Chief Financial Officerconcluded that our disclosure controls and procedures are effective.

 

There havebeen no changes in our internal control over financial reporting that occurredduring the quarter ended September 30, 2004 that have materially affected, orare reasonably likely to materially affect, our internal control over financialreporting.

** **

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**PART II. OTHER INFORMATION**

 

**Item 1.Legal Proceedings****.**

 

From time to timewe have received claims from competitors and other technology providersclaiming that our technology infringes their respective proprietary rights. Onesuch claim has resulted in a legal proceeding being filed against us, which isdescribed below and another claim has resulted in us accruing an amount, whichis described below. In addition, we are involved in certain legal proceedingsin the ordinary course of conducting our business. We believe these claims andlegal proceedings can be resolved without a material adverse effect on ourbusiness, financial condition or results from operations; however, we cannotprovide assurance as to the outcome. Litigation in general, and intellectualproperty litigation in particular, can be expensive and disruptive to normalbusiness operations. Moreover, the results of complex legal proceedings aredifficult to predict.

 

In 2002, wereceived a letter from a consulting firm that has been retained by atelecommunication technology provider to develop and implement a licensingprogram based on the technology provider’s patents. The consulting firmbelieves that we have infringed on the technology provider’s propriety rightsand therefore feels that a licensing agreement between us and the technologyprovider is appropriate. We believe that we did not infringe on the technologyprovider’s proprietary rights; however, because of the cost of defending such amatter in court, we did offer a settlement. Several proposals have been made bythe technology provider and us. We now believe a settlement is probable,although the useful life over which a settlement would be recognized areuncertain. We recorded an accrual as of September 30, 2004 for the low end ofthe settlement range, to be amortized over the estimated useful life. We cannotprovide assurance as to the outcome.

 

In 2002, wereceived a letter from one of our resellers requesting indemnification relatedto a request that the reseller had received for indemnification from acustomer. The customer had received a letter from a third party indicating thatthe customer may be infringing patents held by the third party. To date, ourpatent counsel has not determined the validity or the applicability of thesepatents as they relate to our products or whether the reseller is entitled toindemnification. We believe that this matter can be resolved without a materialadverse effect on our business, financial condition or results of operations;however, we cannot provide assurance as to the outcome.

 

On September 30,2003, Recursion Software, Inc. filed suit in Dallas County Court in Dallas,Texas against us alleging breach of contract and money due under claims ofquantum meruit, unjust enrichment and infringement. Recursion claims that weincorporated Recursion software into one of our products in breach of theunderlying license. We had the case removed to Federal District Court inDallas, Texas, and Recursion has since asserted a copyright infringement claim.No dollar amount has been stated in the action. We believe that we have strongdefenses to the claims and intend to vigorously defend against the action. Webelieve that this matter can be resolved without a material adverse effect onour business, financial condition or results of operations; however, we cannotprovide assurance as to the outcome.

 

In 2002, wereceived a notification from the French government as a result of a tax auditthat had been conducted encompassing the years 1998, 1999, 2000 and 2001. Theseassessments claim various taxes are owed related to Value Added Tax (VAT) andcorporation taxes in addition to what has previously been paid and accrued. Asof September 30, 2004, the assessment related to VAT was approximately $2.9 millionand the assessment related to corporation taxes was approximately $372,000. Ourtax counsel has assessed the possibility of us paying the assessment related toVAT as remote and the assessment related to corporation taxes as reasonablypossible; we have not accrued for these amounts. We are appealing theassessments, but cannot assure you that these matters will be resolved withoutlitigation or that we will not have to pay some or all of the assessments.

 

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**Item 6.Exhibits.**

 

(a)          Exhibits

 

10.21   Form ofAgreement for Incentive Stock Options under 1999 Stock Option and IncentivePlan (incorporated herein by reference from Exhibit No. (d)(3) to the ScheduleTO filed by the Company on April 26, 2001)

 

10.22   Form ofAgreement for Nonqualified Stock Options under 1999 Stock Option and IncentivePlan (incorporated herein by reference from Exhibit No. (d)(4) to the ScheduleTO filed by the Company on April 26, 2001)

 

10.24   Form ofAgreement for Outside Directors Stock Option under Outside Directors StockOption Plan

 

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     Certificationof the Chief Financial 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

 

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

 

32.2     Certification of StephenR. Head, CFO, pursuant to 18 U. S. C. Section 1350, as adopted pursuant toSection 906 of the Sarbanes-Oxley Act of 2002

 

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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)                                                                                      |
|                     |   |                                                                                              |
| Date:  November 15, 2004 | By     | /s/ Stephen R. Head                                                                               |
|                     |   |                                                                                              |
|                     |   | Stephen R. Head                                                                                   |
|                     |   | *Chief Financial Officer, Vice President of  Finance and Administration, Secretary and Treasurer* |
|                     |   | *(Principal Financial Officer and Principal  Accounting Officer)*                                 |

 

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