** **

** **

**UNITED STATES**

**SECURITIESAND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

----

 

**FORM 10-Q**

 

** (Mark One)**

 

**ý          ****QUARTERLY REPORT PURSUANT TOSECTION 13****OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

 

**For the quarterly period endedSeptember 30, 2001**

 

**or**

 

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

 

**For the transition period from____________to____________**

 

###### **Commission File Number000-27385**

 

**INTERACTIVEINTELLIGENCE, INC.**

(Exact name of registrant as specified in its charter)

 

| **Indiana**                                                    | **35-1933097**                    |
|----------------------------------------------------------------|-----------------------------------|
| (State or other jurisdiction of incorporation or organization) | (IRS Employer Identification No.) |

** **

**8909Purdue Road**

**Suite 300**

**Indianapolis, Indiana 46268**

 (Address of principal executiveoffices)

 

**(317) 872-3000**

(Registrant's telephone number)

 

        Indicateby checkmark whether the registrant (1) has filed all reports required to befiled by Section 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days.

 

Yes  ý   No  o

 

        Thenumber of shares of common stock outstanding on October 31, 2001 was15,269,023.

 

 

TABLE OF CONTENTS

 

 
| PART I.  | FINANCIAL INFORMATION                                                                                             |
|----------|-------------------------------------------------------------------------------------------------------------------|
|     |                                                                                                              |
| Item  1. | Condensed  Consolidated Balance Sheets as of September 30, 2001 and December 31, 2000                             |
|     |                                                                                                              |
|     | Condensed  Consolidated Statements of Operations for the three and nine months ended  September 30, 2001 and 2000 |
|     |                                                                                                              |
|     | Condensed  Consolidated Statements of Cash Flows for the nine months ended September 30,  2001 and 2000           |
|     |                                                                                                              |
|     | Notes  to Condensed Consolidated Financial Statements                                                             |
|     |                                                                                                              |
| Item  2. | Management's  Discussion and Analysis of Financial Condition and Results of Operations                            |
|     |                                                                                                              |
| Item  3. | Qualitative  and Quantitative Disclosures About Market Risk                                                       |
|     |                                                                                                              |
|     |                                                                                                              |
|     |                                                                                                              |
| PART II. | OTHER INFORMATION                                                                                                 |
|     |                                                                                                              |
| Item 1.  | Legal Proceedings                                                                                                 |
|     |                                                                                                              |
| Item  2. | Changes  in Securities and Use of Proceeds                                                                        |
|     |                                                                                                              |
| Item 5.  | Other Information                                                                                                 |
|     |                                                                                                              |
| Item 6.  | Exhibits and  Reports on Form 8-K                                                                                 |
|     |                                                                                                              |
|     | Signature                                                                                                         |

 

 

**PARTI.  FINANCIAL INFORMATION**

**Item1.  Condensed Consolidated FinancialStatements and Footnotes.**

 

**Interactive Intelligence, Inc.**

 

**Condensed Consolidated Balance Sheets**

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

 
|                                                                                                                                                                     | **September 30, 2001** |   | **December 31, 2000** |   |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------------------|--------|-----------------------|--------|
| **Assets**                                                                                                                                                               | **(Unaudited)**        |   |                  |   |
| Current assets:                                                                                                                                                          |                   |   |                  |   |
| Cash and cash equivalents                                                                                                                                                | $                      | 6,911  |                  | $      | 1,999 |   |
| Short-term investments                                                                                                                                                   | 14,941                 |   | 10,710                |   |
| Accounts receivable, net of allowance for doubtful accounts accounts  of $1,179 in 2001 and $631 in 2000                                                                 | 8,923                  |   | 9,478                 |   |
| Prepaid expenses                                                                                                                                                         | 1,209                  |   | 970                   |   |
| Other current assets                                                                                                                                                     | 487                    |   | 186                   |   |
| Total current assets                                                                                                                                                     | 32,471                 |   | 23,343                |   |
|                                                                                                                                                                     |                   |   |                  |   |
| Property and equipment, net                                                                                                                                              | 9,704                  |   | 8,389                 |   |
|                                                                                                                                                                     |                   |   |                  |   |
| Long-term investments                                                                                                                                                    | 1,074                  |   | 1,012                 |   |
| Other assets, net                                                                                                                                                        | 641                    |   | 907                   |   |
| Total assets                                                                                                                                                             | $                      | 43,890 |                  | $      | 33,651 |   |
|                                                                                                                                                                     |                   |   |                  |   |
| **Liabilities and shareholders' equity**                                                                                                                                 |                   |   |                  |   |
| Current liabilities:                                                                                                                                                     |                   |   |                  |   |
| Accounts payable and accrued liabilities                                                                                                                                 | $                      | 4,131  |                  | $      | 3,920 |   |
| Accrued compensation and related expenses                                                                                                                                | 1,313                  |   | 1,128                 |   |
| Deferred revenue                                                                                                                                                         | 9,458                  |   | 7,421                 |   |
| Current portion of capital lease obligations                                                                                                                             | 80                     |   | 377                   |   |
| Total current liabilities                                                                                                                                                | 14,982                 |   | 12,846                |   |
|                                                                                                                                                                     |                   |   |                  |   |
| 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; 15,125,959  issued and outstanding at September 30, 2001, 14,343,907 issued and  outstanding at December 31, 2000 | 151                    |   | 143                   |   |
| Additional paid-in capital                                                                                                                                               | 62,673                 |   | 46,995                |   |
| Accumulated other comprehensive income                                                                                                                                   | 79                     |   | 38                    |   |
| Accumulated deficit                                                                                                                                                      | (33,995                | )      | (26,371               | )      |
| Total shareholders' equity                                                                                                                                               | 28,908                 |   | 20,805                |   |
| Total liabilities and shareholders' equity                                                                                                                               | $                      | 43,890 |                  | $      | 33,651 |   |

 

See accompanying notes.

 

 

**Interactive Intelligence, Inc.**

 

**Condensed Consolidated Statements of Operations (unaudited)**

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

** **
|                                       |   | **Three months ended**

**September 30,** |       | **Nine months ended**

**September 30,** |       |
|--------------------------------------------|--------|-------------------------------------------|------------|------------------------------------------|------------|
|                                       |   |                                      |       |                                     |       |   |   |   |   |
|                                       |   | **2001**                                  |       | **2000**                                 |       | **2001** |   | **2000** |   |
| Revenues:                                  |   |                                      |       |                                     |       |   |   |   |   |
| Software                                   |   | $                                         | 7,811      |                                     | $          | 7,689 |   | $ | 25,102 |   | $ | 18,914 |   |
| Services                                   |   | 4,126                                     |       | 2,789                                    |       | 12,223 |   | 7,222 |   |
| Total revenues                             |   | 11,937                                    |       | 10,478                                   |       | 37,325 |   | 26,136 |   |
|                                       |   |                                      |       |                                     |       |   |   |   |   |
| Costs and expenses:                        |   |                                      |       |                                     |       |   |   |   |   |
| Costs of software                          |   | 246                                       |       | 159                                      |       | 549 |   | 356 |   |
| Costs of services                          |   | 3,164                                     |       | 2,781                                    |       | 10,411 |   | 6,997 |   |
| Sales and marketing                        |   | 5,426                                     |       | 4,672                                    |       | 16,727 |   | 12,534 |   |
| Research and development                   |   | 3,814                                     |       | 2,808                                    |       | 11,632 |   | 7,641 |   |
| General and administrative                 |   | 1,643                                     |       | 1,294                                    |       | 5,279 |   | 3,726 |   |
| Special charges                            |   | 1,056                                     |       | -                                        |       | 1,056 |   | - |   |
| Total costs and expenses                   |   | 15,349                                    |       | 11,714                                   |       | 45,654 |   | 31,254 |   |
| Operating loss                             |   | (3,412                                    | )          | (1,236                                   | )          | (8,329 | ) | (5,118 | ) |
|                                       |   |                                      |       |                                     |       |   |   |   |   |
| Interest income, net                       |   | 274                                       |       | 294                                      |       | 941 |   | 868 |   |
| Loss before income taxes                   |   | (3,138                                    | )          | (942                                     | )          | (7,388 | ) | (4,250 | ) |
|                                       |   |                                      |       |                                     |       |   |   |   |   |
| Income taxes                               |   | 95                                        |       | 54                                       |       | 236 |   | 134 |   |
|                                       |   |                                      |       |                                     |       |   |   |   |   |
| Net loss                                   |   | $                                         | (3,233     | )                                        | $          | (996 | ) | $ | (7,624 | ) | $ | (4,384 | ) |
|                                       |   |                                      | ** ** |                                     | ** ** |   | ** ** |   | ** ** |
| Net loss per share:                        |   |                                      | ** ** |                                     | ** ** |   | ** ** |   | ** ** |
| Basic and diluted                          |   | $                                         | (0.21      | )                                        | $          | (0.07 | ) | $ | (0.51 | ) | $ | (0.31 | ) |
|                                       |   |                                      |       |                                     |       |   |   |   |   |
| Shares used to compute net loss per share: |   |                                      |       |                                     |       |   |   |   |   |
| Basic and diluted                          |   | 15,117                                    |       | 14,270                                   |       | 14,987 |   | 14,120 |   |

 

See accompanying notes.

 

 

** Interactive Intelligence, Inc.**

 

**Condensed Consolidated Statements of Cash Flows (unaudited)**

** (in thousands)**

 
|                                                                         |   | **Nine months ended September 30,** |   |
|------------------------------------------------------------------------------|--------|-------------------------------------|--------|
|                                                                         |   | **2001**                            |   | **2000** |   |
| **Operating activities**                                                     |   |                                |   |   |   |
| Net loss                                                                     |   | $                                   | (7,624 | ) | $ | (4,384 | ) |
| Adjustments to reconcile net loss to net cash used by operating  activities: |   |                                |   |   |   |
| Depreciation                                                                 |   | 3,082                               |   | 1,984 |   |
| Amortization of deferred stock-based compensation                            |   | 60                                  |   | 63 |   |
| Changes in operating assets and liabilities:                                 |   |                                |   |   |   |
| Accounts receivable                                                          |   | 555                                 |   | (3,370 | ) |
| Prepaid expenses                                                             |   | (239                                | )      | 17 |   |
| Other current assets                                                         |   | (301                                | )      | 19 |   |
| Accounts payable and accrued liabilities                                     |   | 211                                 |   | 1,607 |   |
| Accrued compensation and related expenses                                    |   | 185                                 |   | 167 |   |
| Deferred revenue                                                             |   | 2,037                               |   | 1,522 |   |
| Net cash used by operating activities                                        |   | (2,034                              | )      | (2,375 | ) |
|                                                                         |   |                                |   |   |   |
| **Investing activities**                                                     |   |                                |   |   |   |
| Purchases of property and equipment, net                                     |   | (4,397                              | )      | (5,162 | ) |
| Purchases of available-for-sale investments                                  |   | (10,156                             | )      | (2,267 | ) |
| Sales of available-for-sale investments                                      |   | 5,904                               |   | 9,374 |   |
| Change in other assets                                                       |   | 266                                 |   | (525 | ) |
| Net cash provided (used) by investing activities                             |   | (8,383                              | )      | 1,420 |   |
|                                                                         |   |                                |   |   |   |
| **Financing activities**                                                     |   |                                |   |   |   |
| Principal payments on capital lease obligations                              |   | (297                                | )      | (445 | ) |
| Proceeds from stock options exercised                                        |   | 296                                 |   | 733 |   |
| Proceeds from issuances of common stock                                      |   | 15,330                              |   | 159 |   |
| Net cash provided by financing activities                                    |   | 15,329                              |   | 447 |   |
|                                                                         |   |                                |   |   |   |
| Net increase (decrease) in cash and cash equivalents                         |   | 4,912                               |   | (508 | ) |
|                                                                         |   |                                |   |   |   |
| Cash and cash equivalents, beginning of period                               |   | 1,999                               |   | 2,235 |   |
| Cash and cash equivalents, end of period                                     |   | $                                   | 6,911  |   | $ | 1,727 |   |

 

 Seeaccompanying notes.

 

InteractiveIntelligence, Inc

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

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

 

Interactive Intelligence,Inc. (“I3” or the “Company”) is a leading provider of software that manages abroad range of customer interactions including traditional telephone calls andfaxes as well as Internet-based interactions such as e-mail, text chat, Webcallback requests, and voice over Net calls. The Company’s products provide a complete communications solutionincluding PBX (private branch exchange), ACD (automated call distributor), IVR (interactivevoice response), unified messaging, and Internet functionality.   The Company currently derives substantiallyall of its revenues from licenses of its Interaction Center Platformäproducts and related services.

 

Principal operations ofthe Company commenced during 1997.  In1998, the Company established a wholly-owned subsidiary in France and a branchoffice in Japan.  In 1999, the Companyestablished branch offices in Korea, the United Kingdom, and the Netherlands.    In 2000, the Company established awholly-owned subsidiary in Australia. The Company’s products are marketed in North America, Central America,South America, Europe, the Asia/Pacific region, Australia, and South Africa.

 

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

 

The balance sheet atDecember 31, 2000 has been derived from the audited financial statements atthat date but does not include all of the information and footnotes required bygenerally accepted accounting principles for complete financial statements.

 

These financialstatements should be read in conjunction with our audited consolidatedfinancial statements for the year ended December 31, 2000, included in the Company’sForm 10-K for the year ended December 31, 2000, filed with the Securities andExchange Commission on March 30, 2001. Our results of operations for any interim period are not necessarilyindicative of the results of operations for any other interim period or for afull fiscal year.

 

**2.     NetLoss Per Common Share**

 

Basic loss per share iscalculated based on the weighted-average number of outstanding commonshares.  Diluted loss per share iscalculated based on the weighted-average number of outstanding common sharesplus the effect of dilutive potential common shares.

 

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

 
|                                                         |   | **Three Months Ended September 30,** |   | **Nine Months Ended September 30,** |   |
|--------------------------------------------------------------|--------|--------------------------------------|--------|-------------------------------------|--------|
|                                                         |   | **2001**                             |   | **2000**                            |   | **2001** |   | **2000** |   |
|                                                         |   |                                 |   |                                |   |   |   |   |   |
| Net Loss:                                                    |   | $                                    | (3,233 | )                                   | $      | (996 | ) | $ | (7,624 | ) | $ | (4,384 | ) |
|                                                         |   |                                 |   |                                |   |   |   |   |   |
| Basic and diluted:                                           |   |                                 |   |                                |   |   |   |   |   |
| Weighted-average shares used to compute  net loss per share: |   | 15,117                               |   | 14,270                              |   | 14,987 |   | 14,120 |   |
|                                                         |   |                                 |   |                                |   |   |   |   |   |
| Basic and diluted net loss per common  share:                |   | $                                    | (0.21  | )                                   | $      | (0.07 | ) | $ | (0.51 | ) | $ | (0.31 | ) |
|                                                         |   |                                 |   |                                |   |   |   |   |   |

 

 

The Company’s calculationof diluted net loss per share excludes potential common shares as the effectwould be antidilutive.  Potential commonshares are composed of shares of common stock of the Company issuable on theexercise of stock options.  Options topurchase 2,482,337 shares of common stock with exercise prices of $0.13 to$50.50 per share were outstanding as of September 30, 2001 and options topurchase 2,183,526 shares of common stock with exercise prices of $0.13 to$50.50 per share were outstanding as of September 30, 2000.

 

During the second quarter of 2001, the Company offered alimited non-compulsory exchange of outstanding employee stock options for newoptions to be granted under the Interactive Intelligence, Inc. 1999 StockOption and Incentive Plan.  The exchangeresulted in the voluntary cancellation of options to purchase approximately218,000 shares of common stock with varying exercise prices ranging from $12.00to $49.00 per share.  The new optionsfor those exchanged will be granted at the fair market value of the commonstock on November 26, 2001.

 

**3.     BankLine of Credit**

 

The Company currently hasan unsecured line of credit with a bank in the amount of $5,000,000 which bearsinterest at the bank’s prime rate (6.0% at September 30, 2001).  As of September 30, 2001, the Company had nooutstanding balance under the line of credit. This line of credit expires April 29, 2002.

 

**4.     Shareholders’Equity**

 

On January 25, 2001 theCompany received an equity investment from Cisco Systems, Inc.  We sold 515,517 shares of common stock at aprice of $29.00 per share, yielding approximately $15 million in cash.

 

**5.     Contingencies**

 

In June 1999 andSeptember 1999, the Company received letters from a competitor in the callcenter market claiming that the Company's products utilize technologiespioneered and patented by that competitor. The Company's patent counsel has reviewed all of the patents listed inthe letters.  Based on the advice of theCompany's patent counsel, the Company believes that its products do notinfringe any of the patents listed in either letter.  The Company has discussed its conclusion with the competitor andhas also discussed possible licensing of certain technologies from thecompetitor.  The Company cannot assureyou that this matter can be resolved amicably without litigation, or that itwill be able to enter into a licensing arrangement on terms and conditions thatwould not have a material adverse effect on the Company's business, financialcondition or results of operations.

In June 2000 and July2000 the Company received letters from two other competitors in the call centermarket claiming that the Company's products utilize technologies pioneered andpatented by those competitors.  Althoughthe Company's patent counsel has not determined the validity of these patents,the Company is discussing the possible licensing of certain technologies withthese competitors.  The Company cannotassure you that these claims can be resolved amicably without litigation, orthat it will be able to enter into licensing arrangements on terms andconditions that would not have a material adverse effect on the Company's business,financial condition or results of operations.

 

**6.     SpecialCharges**

 

                On July 6, 2001 the Companycommenced a restructuring program to reduce expenses and improve efficiency dueto macro-economic and capital spending issues affecting our industry.  In addition to the charge related torestructuring, we also incurred a special charge related to the write-down ofan impaired asset.  The restructuringprogram was substantially completed by the end of the third quarter of fiscal2001.  As a result of the restructuringprogram and the impaired asset, the Company recorded special charges in thethird quarter of 2001 totaling approximately $1.1 million which were classifiedas operating expenses.

 

                The following paragraphs provideinformation relating to the restructuring charge and asset impairment whichwere recorded in the third quarter of fiscal 2001.

 

                Restructuring Program

                The restructuring programconsisted of reducing approximately 10% percent of the Company’s worldwideworkforce and closing certain sales offices. The reduction in staff affected most business functions and geographicregions.  The Company recorded arestructuring charge of approximately $456,000, most of which related  to severance payments and fringe benefits.

 

                Impairment of Asset

                Due to the decline in currentbusiness conditions, the Company wrote down its 19% equity investment inInteractive Portal, Inc.  The Companyrecognized a special charge for this write-down in the amount of approximately$600,000.

 

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

 

## *Forward-LookingInformation*

 

        Certain statements in thisForm 10-Q contain "forward-looking" information (as defined inSection 27A of the Securities Act of 1933, as amended) that involve risks anduncertainties which may cause actual results to differ materially from thosepredicted in the forward-looking statements. Forward-looking statements can beidentified by their use of such verbs as "expects,""anticipates," and "believes" or similar verbs orconjugations of such verbs. If any of our assumptions on which the statementsare based prove incorrect or should unanticipated circumstances arise, ouractual results could materially differ from those anticipated by suchforward-looking statements. The differences could be caused by a number offactors or combination of factors, including, but not limited to, the"Factors Affecting Operating Results" described herein and the RiskFactors described in our Securities and Exchange Commission filings, includingthe Form 10-K filing for the year ended December 31, 2000.

 

### *Overview*

 

        We commenced operations in October 1994.Through the end of 1996, we focused primarily on research and developmentactivities.  Our first product wasreleased in March 1997. In 1997 and 1998, we expanded our operations tocapitalize on the increased market demand for communications and interactionmanagement software. We decided, at the expense of profitability, to continueinvesting significantly in research and development, and to accelerate ourinvestments in marketing, services and sales operations. We had no revenue in1996, and our total revenues were $1.6 million in 1997, $9.0 million in1998,  $19.1 million in 1999 and $38.6million in 2000.  Through the ninemonths ended September 30, 2001, our total revenues were $37.3 million.

We believe ourinvestments in research and development and in marketing, services and salesoperations will continue to be critical to our revenue growth. However, theseinvestments have also significantly increased our operating costs and expenses,contributing to the net losses and operating losses that we have incurred ineach fiscal quarter since our formation. We anticipate that our operating costsand expenses will increase substantially for the foreseeable future as wecontinue to expand our research and development, marketing, services and salesoperations. Accordingly, we are likely to continue to experience losses andnegative cash flows from operations in future quarters. We cannot assure youwhen or if we will achieve profitability or, if achieved, that we will be ableto sustain profitability. Our operating results have varied significantly fromquarter to quarter and may continue to do so in the future. 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.

      On July 6, 2001 we commenced arestructuring program to reduce expenses and improve efficiency due tomacro-economic and capital spending issues affecting our industry.  Thisprogram included a worldwide workforce reduction and consolidation of excessfacilities.  The restructuring program resulted in the reduction of approximately10% of our worldwide workforce.  This reduction affected most businessfunctions and geographic regions. During the third quarter of 2001, we wrote down our investment inInteractive Portal, Inc., a developer of large-scale unified messagingproducts.   Subsequent to September30, 2001, we also acquired the remaining 81% ownership interest of InteractivePortal, Inc.

*HistoricalResults of Operations*

 

        The following table presents certainfinancial data, derived from our unaudited statements of operations, as apercentage of total revenues for the periods indicated.  The operating results for the three and ninemonths ended September 30, 2001 and 2000 are not necessarily indicative of theresults that may be expected for the full year or for any future period.

 

 
|                        |   | **Three  months ended****September 30,** |   | **Nine  months ended****September 30,** |   |
|-----------------------------|--------|------------------------------------------|--------|-----------------------------------------|--------|
|                        |   | **2001**                                 |   | **2000**                                |   | **2001** |   | **2000** |   |
| Revenues:                   |   |                                     |   |                                    |   |   |   |   |   |
| Software                    |   | 65                                       | %      | 73                                      | %      | 67 | % | 72 | % |
| Services                    |   | 35                                       |   | 27                                      |   | 33 |   | 28 |   |
| Total revenues              |   | 100                                      |   | 100                                     |   | 100 |   | 100 |   |
|                        |   |                                     |   |                                    |   |   |   |   |   |
| Costs and expenses:         |   |                                     |   |                                    |   |   |   |   |   |
| Costs of  software          |   | 2                                        |   | 2                                       |   | 1 |   | 1 |   |
| Costs of  services          |   | 27                                       |   | 27                                      |   | 28 |   | 27 |   |
| Sales and  marketing        |   | 45                                       |   | 44                                      |   | 45 |   | 48 |   |
| Research and  development   |   | 32                                       |   | 27                                      |   | 31 |   | 29 |   |
| General and  administrative |   | 14                                       |   | 12                                      |   | 14 |   | 14 |   |
| Special charges             |   | 9                                        |   | 0                                       |   | 3 |   | 0 |   |
| Total costs and  expenses   |   | 129                                      |   | 112                                     |   | 122 |   | 119 |   |
|                        |   |                                     |   |                                    |   |   |   |   |   |
| Operating loss              |   | (29                                      | )      | (12                                     | )      | (22 | ) | (19 | ) |
| Interest income,  net       |   | 3                                        |   | 3                                       |   | 3 |   | 3 |   |
| Loss before  income taxes   |   | (26                                      | )      | (9                                      | )      | (19 | ) | (16 | ) |
| Income taxes                |   | 1                                        |   | 1                                       |   | 1 |   | 1 |   |
| Net loss                    |   | (27                                      | )%     | (10                                     | )%     | (20 | )% | (17 | )% |

 

 

### *Revenues*

 

        Our totalrevenues increased 14% from $10.5 million for the three months ended September30, 2000 to $11.9 million for the three months ended September 30, 2001.  Total revenues increased 43% from $26.1million for the nine months ended September 30, 2000, to $37.3 million for thenine months ended September 30, 2001. Non-North American revenues decreased from  $3.3 million for the three months ended September 30, 2000 to$2.3 million for the three months ended September 30, 2001.  However, overall non-North American revenuesincreased from $6.9 million for the nine months ended September 30, 2000 to$8.3 million for the nine months ended September 30, 2001.  Our revenues are derived primarily fromsoftware license fees and charges for services, including product maintenance,education services, and professional services. The increase in total revenues resulted primarily from increases in thenumber of both new and existing software licenses and product maintenancerevenues. We believe that the percentage increases in revenues achieved inprior periods should not be anticipated in future periods.  We anticipate that software revenues willcontinue to represent the majority of our revenues for the foreseeable future.

 

*Software.*  Our software revenues increased 2% from $7.7million for the three months ended September 30, 2000, to $7.8 million for thethree months ended September 30, 2001. Software revenues increased 33% from $18.9 million for the nine monthsended September 30, 2000, to $25.1 million for the nine months ended September30, 2001.  Despite a challenging globaleconomy, the increase in software revenues resulted from increased marketpenetration for our products, increased production from our worldwide resellerchannel, increased direct end-user transactions in North America andnon-recurring OEM revenue from one partner, which accounted for 17% and 5% oftotal revenue for the three and nine months ended September 30, 2001,respectively.

 

*Services.*  Services revenues increased 48% from $2.8million for the three months ended September 30, 2000, to $4.1 million for thethree months ended September 30, 2001. Services revenues increased 69% from $7.2 million for the nine monthsended September 30, 2000, to $12.2 million for the nine months ended September30, 2001.  The increase in servicesrevenues was primarily due to an increase in product maintenance revenues,which is related to our growing installed base of end-user customers.  We also realized education revenues andimplementation and customization revenues from our professional servicesorganization.

 

 

### *Costs and Expenses*

 

### *         *Total costs and expenses increased 31% from $11.7million for the three months ended September 30, 2000, to $15.3 million for thethree months ended September 30, 2001. Similarly, total costs and expenses increased 46% from $31.3 million forthe nine months ended September 30, 2000, to $45.7 million for the nine monthsended September 30, 2001.  The increasein amount was primarily due to increases in investments in our research anddevelopment, marketing,  sales andservices efforts and special charges.

 

*Costsof Software*.  Costs ofsoftware consist primarily of product royalties related to the use of thirdparty technologies in our products and, to a lesser extent, software packagingcosts, which include product media, duplication and documentation.  Costs of software increased from $159,000for the three months ended September 30, 2000, to $246,000 for the three monthsended September 30, 2001. This represents 2% and 3% of software revenues forthe three months ended September 30, 2000 and 2001, respectively.  Costs of software increased from $356,000for the nine months ended September 30, 2000 to $549,000 for the nine monthsended September 30, 2001. This represents 2% of software revenues in bothperiods. The increases were primarily due to royalties owed as a result ofhigher software revenues associated with our Interaction Center  PlatformTM and other related products. Weexpect product royalties to continue to increase as we release additionalproducts, release additional versions of our existing products, and integrateadditional third-party functions and features into our product offerings.

*Costsof Services.*  Costs ofservices consist primarily of compensation expenses for technical support,education, and professional services personnel and other costs associated withsupporting our resellers and end-user customers.  Costs of services increased from $2.8 million for the threemonths ended September 30, 2000, to $3.2 million for the three months endedSeptember 30, 2001.  Costs of servicesincreased from $7.0 million for the nine months ended September 30, 2000, to$10.4 million for the nine months ended September 30, 2001.  As a percentage of services revenues, costof services decreased from  100% and 77%for the three months ended September 30, 2000 and 2001, respectively, anddecreased from 97% and 85% for the nine months ended September 30, 2000 and2001, respectively. The increase in amount was due to an ongoing effort tomaximize our reseller effectiveness and end-user customer satisfaction throughthe development and expansion of our technical support, education andprofessional services organizations.  Weexpect that costs of services will continue to increase as services revenuesincrease and as we make continued investments to support our end-user customerbase and resellers.

 

*Salesand Marketing.*  Salesand marketing expenses consist of trade shows, advertising, telemarketingcampaigns, public relations and other promotional expenses, compensationexpenses, including sales commissions, and travel expenses.  Sales and marketing expenses increased from$4.7 million for the three months ended September 30, 2000, to $5.4 million forthe three months ended September 30, 2001. Sales and marketing expenses increased from $12.5 million for the nine monthsended September 30, 2000 to $16.7 million for the nine months ended September30, 2001.  The dollar increases reflectthe expansion of our worldwide sales and marketing organizations, higher salescompensation expenses associated with higher software revenues, and increasesin worldwide marketing activities such as marketing communication efforts,trade shows and advertising.  Wecurrently plan to continue to invest significantly in sales and marketingefforts.

 

*Researchand Development.* Research and development expenses consist primarily of compensationexpenses for our developers and third party efforts to develop and enhance ourproducts, including adapting our products for specific non-English languagesand allowing our products to effectively run with alternative hardwareconfigurations.  Research anddevelopment expenses increased from $2.8 million for the three months endedSeptember 30, 2000, to $3.8 million for the three months ended September 30,2001.   Research and developmentexpenses increased from $7.6 million for the nine months ended September 30,2000, to $11.6 million for the nine months ended September 30, 2001.  Currently, all costs related to research anddevelopment of our products are charged to research and development expense asincurred.  The dollar increases in researchand development expenses were due to the hiring of software developers andthird party efforts required to enhance our existing products, investigate,design and develop new products, and localize our products into otherlanguages, including French, German, Italian, Japanese, Korean, Portuguese,Spanish, and Taiwanese.  We believe thata significant investment in research and development has been, and willcontinue to be, critical to market acceptance and additional market penetrationof our products.

 

*Generaland Administrative.* General and administrative expenses consist primarily of compensationfor our administrative, financial, and information technology personnel, and anumber of non-allocable costs, including legal and other professional servicefees.  General and administrativeexpenses increased from $1.3 million for the three months ended September 30,2000, to $1.6 million for the three months ended September 30, 2001.  General and administrative expensesincreased from $3.7 million for the nine months ended September 30, 2000, to$5.3 million for the nine months ended September 30, 2001.  The increase was primarily due to theaddition of administrative personnel necessary to support our growing operationsand an increased amount of bad debt expense.  We believe our general and administrative expenses will continue toincrease as we expand our administrative infrastructure and incur legal andother professional service fees.

 

*Special Charges.*  For the three and nine months endedSeptember 30, 2001, we incurred a restructuring charge of approximately$456,000, primarily consisting of severance payments, benefits and otherrelated costs from the reduction of our workforce by 10%, or approximately 40people.

 

As a result of the decline in Interactive Portal’s current businesscondition, we wrote down the carrying value of our investment in InteractivePortal, which resulted in a non-recurring charge of approximately$600,000.  Subsequent to September 30,2001, we acquired the remaining 81% of Interactive Portal, Inc.

*Interest income, net*

 

                Interest income,net is generated primarily from invested funds from our initial public offeringcompleted in September 1999 and the equity investment made by Cisco Systems,Inc. (“Cisco”) on January 25, 2001.  Netinterest income decreased from $294,000 for the three months ended September30, 2000 to $274,000 for the three months ended September 30, 2001. Thedecrease for the three-month comparison period can be attributed to thesubstantial decrease in interest rates, offset partially by the Cisco equityinvestment.  Net interest incomeincreased from $868,000 for the nine months ended September 30, 2000 to$941,000 for the nine months ended September 30, 2001.  The increase for the nine-month comparisonperiod can be attributed to the interest earned on the funds provided by theequity investment made by Cisco, partially offset by lower interest rates.

 

### * *

### *Income taxes*

 

        For U.S.corporate income tax purposes, we did not recognize a tax benefit related toU.S. federal or state income taxes during the three months or nine months endedSeptember 30, 2000 or September 30, 2001 because of the uncertainty ofeventually realizing these benefits.

 

International taxexpense increased from $54,000 for the three months ended September 30, 2000 to$95,000 for the three months ended September 30, 2001.  International tax expense increased from$134,000 for the nine months ended September 30, 2000 to $236,000 for the ninemonths ended September 30, 2001.  Theincreases are attributable to our expanding international presence.

### * *

### * *

### *Liquidity and Capital Resources*

 

        As ofSeptember 30, 2001, we had cash and cash equivalents of $6.9 million, $14.9million in short term investments, a working capital balance of $17.5 million,and  $1.1 million in long-terminvestments.

 

        In September 1999, we sold 3.0 millionshares of common stock in our initial public offering, generating $39.0 millionin cash, before offering expenses. Prior to our initial public offering, wefunded our operations primarily through equity and debt infusions from ourprincipal stockholder, Dr. Brown, and a $5.0 million equity investment byDialogic Investment Corporation (now owned by Intel Corporation), andborrowings under commercial lines of credit.

 

        OnJanuary 25, 2001 we received an equity investment from Cisco Systems, Inc.  We sold 515,517 shares of common stock at aprice of $29.00 per share, yielding approximately $15.0 million in cash.

 

        Our operating activities resulted in netcash outflows of $2.4 million for the nine months ended September 30, 2000 and$2.0 million for the nine months ended September 30, 2001.  The net operating cash outflow for the firstnine months of 2000 was primarily the result of our operating loss and anincrease in accounts receivable, partially offset by an increase in accountspayable, deferred revenue and the non-cash depreciation amount.  The net operating cash outflow for the firstnine months of 2001 was primarily due to the operating loss,  primarily offset by an increase in deferredrevenue and the non-cash depreciation amount.

 

        Our investing activities have consistedprimarily of capital expenditures for property and equipment and purchases andsales of investments.  Our activitiesresulted in a $1.4 million inflow for the nine month period ended September 30,2000 and a $8.4 million outflow for the nine month period ending September 30,2001.  The outflow for the nine monthsended September 30, 2001 was attributed to net purchases of available-for-saleinvestments and capital expenditures for property and equipment.  At September 30, 2001, we did not have anymaterial commitments for future capital expenditures.

        For the ninemonths ended September 30, 2000 we generated $447,000 in net proceeds fromfinancing activities that included stock options exercised, partially offset byscheduled repayments of our capital lease obligations. For the nine monthsended September 30, 2001 we generated $15.3 million in net proceeds fromfinancing activities that were primarily attributable to the shares issued inconnection with the Cisco equity investment. At September 30, 2001, we had no amounts outstanding on our line ofcredit and were in compliance with all related covenants and restrictions.  This line of credit is currently scheduledto expire on April 29, 2002.

 

        We believe that our existing cash and cash equivalents andshort-term investments will be sufficient to meet our working capital andcapital expenditure requirements for at least the next 12 months. After thattime, we may require additional funds to support our working capitalrequirements or for other corporate purposes, and we may seek to raiseadditional funds through public or private equity or debt financings or fromother sources. We cannot assure you that additional financing will be availableat all or that, if available, will be on terms favorable to us or that anyadditional financing will not dilute your ownership interest in InteractiveIntelligence.

 

 

*FactorsAffecting Operating Results*

 

**OURLIMITED OPERATING HISTORY MAKES FINANCIAL FORECASTING DIFFICULT AND, IN****ASSESSINGOUR PROSPECTS, YOU SHOULD CONSIDER OUR EARLY STAGE OF DEVELOPMENT AND****PRESENCEIN A NEW AND RAPIDLY EVOLVING INDUSTRY**

 

        Ourlimited operating history makes it difficult to forecast our future operatingresults. We commenced operations in October 1994, but did not begin shipping anInteraction Center Platformä-basedproduct until 1997.  In 1999, we beganshipping Interaction Recorderâ, InteractionDialerTM, and e-FAQTM. Accordingly, you should assess our prospects in light ofthe risks and difficulties frequently encountered by companies in the earlystage of development, particularly companies in new and rapidly evolvingindustries.

 

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

 

        We havenot operated profitably to date. In addition to our loss of  $7.6 million for the nine months endedSeptember 30, 2001, we incurred net losses of $4.6 million, $7.1 million, and$7.4 million in 2000, 1999, and 1998, respectively. At September 30, 2001, wehad accumulated losses since inception of $34.0 million. We intend to continueto make significant investments in our research and development, marketing,services and sales operations. We anticipate that these expenses couldsignificantly precede any revenues generated by the increased spending. As aresult, we are likely to continue to experience losses and negative cash flowfrom operations in future quarters. If we do become profitable, we may notsustain or increase our profitability.

 

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

 

        Ouroperating results have varied significantly from quarter to quarter and maycontinue to do so in the future depending on a number of factors affecting usor our industry, including many that are beyond our control. As a result, webelieve that period-to-period comparisons of our operating results are notnecessarily meaningful, and you should not rely on them as an indication of ourfuture performance. In addition, our operating results in a future quarter orquarters may fall below expectations of securities analysts or investors and,as a result, the price of our common stock may fluctuate.

        Because we do notknow when our potential end-user customers will place orders and finalizecontracts, we cannot accurately forecast our revenues and operating results forfuture quarters. We recognize revenues on satisfaction of the requirements ofAICPA Statement of Position 97-2, which generally occurs in the same quarterthat the order is received. As a result, our quarterly revenues and operatingresults depend primarily on the size, quantity and timing of orders receivedfor our products during each quarter. If a large number of orders or severallarge orders do not occur or are deferred or delayed, our revenues in a quartercould be substantially reduced. This risk is heightened by the significantinvestment and executive level decision making typically involved in ourend-user customers' decisions to license our products. Since a large portion ofour operating expenses, including rent and salaries, is fixed and difficult toreduce or modify, our business, financial condition or results of operationscould be materially adversely affected if revenues do not meet ourexpectations.

 

        Becauseof our early stage of development and limited number of products, changes inpricing policies and the timing of the development, announcement and sale ofnew or upgraded versions of our products are some of the additional factorsthat could cause our revenues and operating results to vary significantly fromquarter to quarter.

 

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

 

        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. It also makes it difficult for usto forecast product license revenues. Because of the unique characteristics ofour products, our prospective end-user customers' decisions to license ourproducts often require significant investment and executive level decisionmaking. We believe that many companies currently are not aware of the benefitsof interaction management software of the type we license or of our productsand capabilities. For this reason, we must provide a significant level ofeducation to prospective end-user customers about the use and benefits of ourproducts, which can cause potential end-user customers to take many months tomake these decisions. As a result, sales cycles for end-user customer ordersvary substantially from customer to customer. Excessive delay in product salescould materially adversely affect our business, financial condition or resultsof operations.

 

       The length of the sales cycle for end-user customer ordersdepends on a number of other factors over which we have little or no control,including:

 

       - an end-user customer's budgetary constraints;

 

       - the timing of an end-user customer's budget cycles;

 

       - concerns by end-user customers about the introduction of newproducts by us or our competitors; and

 

       - downturns in general economic conditions, includingreductions in demand for call center services.

 

In addition, the sales cycle for our products ininternational markets has been, and is expected to continue to be, longer thanthe sales cycle in the United States. The average sales cycle for our productsmay lengthen as we expand internationally.

 

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

 

       As the complexity of our product technology and our resellerand other third-party relationships have increased, the management of thoserelationships and the negotiation of contractual terms sufficient to protectour rights and limit our potential liabilities has become more complicated, andwe expect this trend to continue in the future. As a result, our inability tosuccessfully manage these relationships or negotiate sufficient contractualterms could have a material adverse effect on us.

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

 

       The market for our software products is highly competitiveand, because there are relatively low barriers to entry in the software market,we expect competition to increase significantly in the future. In addition,because our industry is new and evolving and characterized by rapidtechnological change, it is difficult for us to predict whether, when and bywhom new competing technologies or new competitors may be introduced into ourmarkets. Currently, our competition comes from several different marketsegments, including computer telephony platform developers, computer telephonyapplications software developers and telecommunications equipment vendors. Wecannot assure you that we will be able to compete effectively against currentand future competitors. In addition, increased competition or other competitivepressures may result in price reductions, reduced margins or loss of marketshare, any of which could have a material adverse effect on our business,financial condition or results of operations.

 

       Many of our current and potential competitors have longeroperating histories, significantly greater financial, technical, marketing,customer service and other resources, greater name recognition and a largerinstalled base of customers than we do. As a result, these competitors may beable to respond to new or emerging technologies and changes in customerrequirements faster and more effectively than we can, or to devote greater resourcesto the development, promotion and sale of products than we can. Current andpotential competitors have established, and may in the future establish,cooperative relationships among themselves or with third parties, includingmergers or acquisitions, to increase the ability of their products to addressthe needs of our current or prospective end-user customers. If thesecompetitors were to acquire significant market share, it could have a materialadverse effect on our business, financial condition or results of operations.

 

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

 

       Our ability to achieve revenue growth in the future willdepend in part on our success in maintaining successful relationships with ourexisting and future resellers and OEM partners and in recruiting and trainingadditional resellers and OEM partners. We rely primarily on resellers to marketand support our products, and plan on relying more on our OEM partners in thefuture. We are still developing and refining our reseller and OEM distributionnetworks and may be unable to attract additional resellers with both voice and dataexpertise or appropriate OEM partners that will be able to market our productseffectively and that will be qualified to provide timely and cost-effectivecustomer support and service. We generally do not have long-term or exclusiveagreements with our resellers or OEM partners, and the loss of specific largerresellers or OEM partners or a significant number of resellers or OEM partnerscould materially adversely affect our business, financial condition or resultsof operations.

 

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

 

       The market for our products is characterized by rapidtechnological change, frequent new product introductions and enhancements,uncertain product life cycles and changing end-user customer demands. Theintroduction of products embodying new technologies and the emergence of newindustry standards could render existing products obsolete or unmarketable andcause us to incur significant development costs.

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

 

The use of the Internet as a commercial marketplace isat an early stage of development. Demand and market acceptance for recently introducedproducts and services available over the Internet are still uncertain. Inaddition, governmental regulation of the Internet, such as imposing sales andother taxes, access charges, and pricing controls and inhibiting cross–bordercommerce, may reduce the use of the Internet by businesses for their electroniccommerce and customer service needs. To date, governmental regulations have notmaterially restricted commercial use of the Internet. However, the legal andregulatory environment that pertains to the Internet is uncertain and maychange. New regulations could reduce the use of the Internet by our end–usercustomers and, in turn, their customers. The lack of acceptance of the Internetas a forum for conducting business could reduce growth in demand for ourproducts and limit the growth of our revenue.

**OUR BUSINESS WILL BE ADVERSELYAFFECTED IF WEB–BASED ELECTRONIC BUSINESS SOLUTIONS ARE NOT WIDELYADOPTED**

Our products address a new and emerging market for Web–based,interactive electronic business solutions. Therefore, our future successdepends on the widespread adoption of the Web as a primary medium for commerceand business applications. The failure of this market to develop, or a delay inthe development of this market, could have a material adverse effect on ourbusiness, financial condition or results of operations. The Web hasexperienced, and is expected to continue to experience, significant user andtraffic growth, which has, at times, caused user frustration with slow accessand download times. The Web infrastructure may not be able to support thedemands placed on it by the continued growth on which our success depends.Moreover, critical issues concerning the commercial use of the Web, such assecurity, reliability, cost, accessibility and quality of service, remainunresolved and may negatively affect the growth of Web use or theattractiveness of commerce and business communication over the Web. Inaddition, the Web could lose its viability due to delays in the development oradoption of new standards and protocols to handle increased activity or due toincreased government regulation and taxation of Internet commerce.

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

 

       Our products currently run only on Microsoft Windows NT®servers. In addition, our products use other Microsoft Corporationtechnologies, including Microsoft Exchange Server® and Microsoft SQL Server®. Adecline in market acceptance for Microsoft technologies or the increasedacceptance of other server technologies could cause us to incur significantdevelopment costs and could have a material adverse effect on our ability tomarket our current products. Although we believe that Microsoft technologieswill continue to be widely used by businesses, we cannot assure you thatbusinesses will adopt these technologies as anticipated or will not in thefuture migrate to other computing technologies that we do not currentlysupport. In addition, our products and technologies must continue to becompatible with new developments in Microsoft technologies.

 

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

 

       We believe that our future business prospects depend in largepart on our ability to maintain and improve our current products and to developnew products on a timely basis. Our products will have to achieve marketacceptance, maintain technological competitiveness and meet an expanding rangeof end-user customer requirements. As a result of the complexities inherent inour products, major new products and product enhancements require longdevelopment and testing periods. We may not be successful in developing and marketing,on a timely and cost effective basis, product enhancements or new products thatrespond to technological change, evolving industry standards or end-usercustomer requirements. We may also experience difficulties that could delay orprevent the successful development, introduction or marketing of productenhancements, and our new products and product enhancements may not achievemarket acceptance. Significant delays in the general availability of newreleases of our products or significant problems in the installation orimplementation of new releases of our products could have a material adverseeffect on our business, financial condition or results of operations.

**SLOWGROWTH, OR A DECLINE IN DEMAND FOR INTERACTION MANAGEMENT SOFTWARE OF THE TYPE WE****LICENSE,COULD MATERIALLY ADVERSELY AFFECT OUR GROWTH PROSPECTS**

 

       If the demand for interaction management software of the typewe license does not grow within each of our three targeted markets, our abilityto grow our business could be materially adversely affected. All of ourrevenues have been generated from licenses of our Interaction Center Platformäsoftware or complementary products, and related support, educational andprofessional services. We expect these products and services to account for themajority of our revenues for the foreseeable future. Although we believe demandfor the functions performed by our products is high, and demand has grown inrecent years, particularly among call centers, the market for our products andservices is still emerging. Further, our growth plans require us tosuccessfully attract enterprise and service provider end-user customers.

 

**IF OUR END–USER CUSTOMERS DONOT PERCEIVE OUR PRODUCTS OR THE RELATED SERVICES PROVIDED BY US OR OURRESELLERS OR OEM PARTNERS TO BE EFFECTIVE OR OF HIGH QUALITY, OUR BRAND ANDNAME RECOGNITION WILL SUFFER**

We believe that establishing and maintaining brand andname recognition is critical for attracting, retaining and expanding end–usercustomers in our target markets. We also believe that the importance ofreputation and name recognition will increase as competition in our marketincreases. Promotion and enhancement of our name will depend on theeffectiveness of our marketing and advertising efforts and on our success inproviding high–quality products and related services, neither of whichcan be assured. If our end–user customers do not perceive our products orrelated services to be effective or of high quality, our brand and namerecognition would suffer which could have a material adverse effect on ourbusiness, financial condition or results of operations.

**IFWE ARE UNABLE TO ADAPT OUR SOFTWARE IN A WAY THAT WILL PERMIT US TO SERVE****LARGE,SINGLE-SITE END-USER CUSTOMERS, THE MARKETABILITY OF OUR PRODUCTS COULD BE****ADVERSELYAFFECTED**

 

Our products cannot currently meet the communicationsneeds of organizations with more than 500 users at a single call centerlocation and cannot currently meet the communication needs of organizationswith more than 1,000 users at a single enterprise location. As theseorganizations expand to include multiple locations, our products can becustomized to increase the number of telephone lines, extensions and users. Wewill need to adapt our software to serve larger single–siteorganizations.  Although we arecurrently developing and testing solutions that would enable our software tosignificantly increase the number of users that our products can serve at asingle location, we cannot assure you that we will be able to successfullyintroduce this technology into a currently available version of ourproducts.  Further, we may not be ableto adapt our software in a timely or cost effective manner in a way that willpermit us to serve these customers. This inability could have a materialadverse effect on our business, financial condition or results of operations.

**OUR MAIN SUPPLIERS OF VOICEPROCESSING BOARDS MAY BECOME UNWILLING OR UNABLE TO CONTINUE TO MANUFACTURE ANDSUPPLY US WITH VOICE PROCESSING BOARDS, REQUIRING US TO INTRODUCE A SUBSTITUTESUPPLIER WHICH COULD PROVE DIFFICULT OR COSTLY**

DialogicCorporation, a subsidiary of Intel Corporation, and AcuLab plc are our primarysuppliers of the voice processing boards that are used by a majority of ourend-user customers for the operation of our products.  If a majority of future end-user customers desire to utilize thevoice processing boards to enable our products and these suppliers becomeunable or unwilling to continue to manufacture and supply these voiceprocessing boards in the volume, price and technical specifications we require,then we would have to adapt our products to a substitute supplier.  We may not be able to successfully introducevoice processing boards made by a substitute supplier into the availableversions of our products. In addition, introducing a substitute supplier ofvoice processing boards could result in unforeseen additional productdevelopment or customization costs and could also introduce hardware andsoftware operating or compatibility problems. We cannot assure you that theseissues will not affect product shipments, will not be costly to correct, willnot damage our reputation in the markets in which we operate, or will not havea material adverse affect on our business, financial condition or results ofoperations.

        In addition, Dialogic Corporation’s CT MediaTM offers some ofthe functionality that our Interaction Center Platformäproducts provide and consequently could make it easier for competitors orpotential competitors to provide products competitive with ours. If CT MediaTMwere to become an industry standard, our failure to adopt it could disadvantageus in competitive situations.  Inaddition, although neither of our primary suppliers of voice processing boardsnor their affiliates currently offer a product that competes with ourInteraction Center Platformä products, theycould potentially develop a competitive or superior product.

 

**WEMAY NOT BE ABLE TO PROTECT OUR PROPRIETARY RIGHTS ADEQUATELY, WHICH COULD****ALLOWTHIRD PARTIES TO COPY OR OTHERWISE OBTAIN AND USE OUR TECHNOLOGY WITHOUT****AUTHORIZATION**

 

We regard our software products as proprietary. In aneffort to protect our proprietary rights, we rely primarily on a combination ofcopyright, trademark and trade secret laws, as well as licensing and otheragreements with consultants, suppliers, strategic and OEM partners, resellersand end–user customers, and employee and third–party non–disclosureagreements. These laws and agreements provide only limited protection of ourproprietary rights. In addition, we have not signed agreements containing thesetypes of protective provisions in every case, and the contractual provisionsthat are in place and the protection they provide vary and may not provide uswith adequate protection in all circumstances. Although we have filed patentapplications directed to several inventions embodied in our software products,we currently hold no patents. We hold sevenU.S. trademark registrations and 12 foreign trademark registrations, and havenumerous other trademark applications pending worldwide, as well as havingcommon law rights in other trademarks and service marks.  We hold one registered copyright.Because our means of protecting our proprietary rights may not be adequate, itmay be possible for a third party to copy or otherwise obtain and use ourtechnology without authorization. A third party could also develop similartechnology independently. In addition, the laws of some countries in which wesell our products do not protect our software and intellectual property rightsto the same extent as the laws of the United States. Unauthorized copying, useor reverse engineering of our products could materially adversely affect ourbusiness, results of operations or financial condition.

We license technology that is embedded in our productsfrom others. If one or more of these licenses terminates or cannot be renewedon satisfactory terms, we would have to modify the affected products to usealternative technology or eliminate the affected product function, either ofwhich could have a material adverse effect on us.

**INFRINGEMENTCLAIMS COULD ADVERSELY AFFECT US**

 

In June 1999 and September 1999, the Company received letters from acompetitor in the call center market claiming that the Company's productsutilize technologies pioneered and patented by that competitor.  The Company's patent counsel has reviewedall of the patents listed in the letters. Based on the advice of the Company's patent counsel, the Companybelieves that its products do not infringe any of the patents listed in eitherletter.  The Company has discussed itsconclusion with the competitor and has also discussed possible licensing ofcertain technologies from the competitor. The Company cannot assure you that this matter can be resolved amicablywithout litigation, or that it will be able to enter into a licensingarrangement on terms and conditions that would not have a material adverseeffect on the Company's business, financial condition or results of operations.

In June 2000 and July2000 the Company received letters from two other competitors in the call centermarket claiming that the Company's products utilize technologies pioneered andpatented by those competitors.  Althoughthe Company's patent counsel has not determined the validity of these patents,the Company is discussing the possible licensing of certain technologies withthese competitors.  The Company cannotassure you that these claims can be resolved amicably without litigation, orthat it will be able to enter into licensing arrangements on terms andconditions that would not have a material adverse effect on the Company'sbusiness, financial condition or results of operations.

 

Other third parties couldclaim that our technology infringes their proprietary rights. As the number ofsoftware products in our target markets increases and the functionality ofthese products overlap, we believe that software developers may faceinfringement claims. For example, various patent rights have been assertedagainst interfaces between PBX hardware and computer network systems. Althoughwe believe that our products do not infringe any of these patents because,among other reasons, our products are designed to replace PBXs and not tocreate such interfaces, if these patents were interpreted broadly, claims ofinfringement of these patents could have a material adverse affect on us.

 

Infringement claims, even if without merit, can betime consuming and expensive to defend. A third party asserting infringementclaims against us or our customers with respect to our current or futureproducts may require us to enter into costly royalty arrangements orlitigation, or otherwise materially adversely affect us.

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

 

Our success depends in large part on the continuedservice of our key personnel, particularly Dr. Donald E. Brown, our ChiefExecutive Officer and principal stockholder, and Dr. Michael D. Gagle, ourChief Scientist. The loss of the services of either of these individuals or anykey personnel could have a material adverse effect on our business, financialcondition or results of operations.  Wedo not have key man life insurance on any of our employees.  Our future success also depends on ourability to attract, train, assimilate and retain additional qualifiedpersonnel. Competition for persons with skills in the software industry isintense, particularly for those with relevant technical and/or 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.

**OUR WORKFORCE REDUCTION AND FINANCIALPERFORMANCE MAY ADVERSELY AFFECT THE MORALE AND PERFORMANCE OF OUR PERSONNELAND OUR ABILITY TO HIRE NEW PERSONNEL**

        In connection with our effort tostreamline operations, reduce costs and rationalize our staffing and structure,we had a reduction in the worldwide workforce of approximately ten percent.  There have been and may continue to besubstantial costs associated with the workforce reduction related to severanceand other employee-related  costs, andour restructuring plan may yield unanticipated consequences, such as attritionbeyond our planned reduction in workforce. As a result of these reductions, our ability to respond to unexpectedchallenges may be impaired and we may be unable to take advantage of newopportunities. The reduction in workforce may reduce employee morale and maycreate concern among existing employees about job security, which may lead toincreased turnover.  This reduction inheadcount may subject us to the risk of litigation.  In addition, recent trading levels of our common stock havedecreased the value of the stock options granted to employees pursuant to ourstock option plans.  As a result ofthese factors, our remaining personnel may seek employment with larger, moreestablished companies or companies they perceive as having less volatile stockprices.

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

 

       In the future we may pursue additional acquisitions todiversify our product offerings and customer base or for other strategicpurposes. We have no prior history of making material acquisitions and wecannot assure you that any future acquisitions will be successful. Thefollowing are some of the risks associated with acquisitions that could have amaterial adverse effect on our business, financial condition or results of operations:

 

-      We cannot assure that any acquiredbusinesses will achieve anticipated revenues, earnings or cash flow.

 

-      We may be unable to integrate acquiredbusinesses successfully and realize anticipated economic, operational and otherbenefits in a timely manner, particularly if we acquire a business in a marketin which we have limited or no current expertise, or with a corporate culturedifferent from our own. If we are unable to integrate acquired businessessuccessfully, we could incur substantial costs and delays or other operational,technical or financial problems.

 

-      Acquisitions could disrupt our ongoingbusiness, distract management, divert resources and make it difficult tomaintain our current business standards, controls and procedures.

 

-      We may finance future acquisitions byissuing common stock for some or all of the purchase price. This could dilutethe ownership interests of our stockholders. We may also incur additional debtor be required to recognize amortization expense related to goodwill and otherintangible assets purchased in future acquisitions.

 

-      We would be competing with other firms,many of which have greater financial and other resources, to acquire attractivecompanies. We believe this competition will increase, making it more difficultto acquire suitable companies on acceptable terms.

 

**OURINTERNATIONAL OPERATIONS AND EXPANSION INVOLVE FINANCIAL AND OPERATIONAL****RISKS**

 

       The expansion of our international operations will requiresignificant management attention and financial resources to establishadditional foreign operations, hire additional personnel and recruit additionalinternational resellers. Non-North American revenues accounted for 25%, 19%,and 16% of our total revenues in 2000, 1999, and 1998, respectively. To date,our products have been licensed outside North America primarily in WesternEurope, South Africa, and Australia. We are also expanding our marketingefforts in Japan, Korea, China and Central and South America. We intend tocontinue to expand our international operations and enter additionalinternational markets. Revenues from international expansion may be inadequateto cover the expenses of international expansion. In addition to foreigncurrency fluctuation risks described in the next risk factor, other risksinherent in our international business activities, in the countries in which wehave licensed our products to date and in those countries in which we intend toexpand, generally could include the following:

 

-       economic and political instability;

 

-       unexpected changes in foreign regulatory requirements andlaws;

 

-       tariffs and other trade barriers;

 

-       timing, cost and potential difficulty ofadapting our software products to the local language in those foreign countriesthat do not use the alphabet that English uses, such as Japan, Korea and China;

 

-       lack of acceptance of our products in foreign countries;

 

-       longer sales cycles and accounts receivable payment cycles;

 

-       potentially adverse tax consequences; and

 

-       restrictions on the repatriation of funds.

** **

**FLUCTUATIONS IN THE VALUEOF FOREIGN CURRENCIES COULD RESULT IN LOSSES**

Our international revenues are generally denominatedin U.S. Dollars, but our international expenses are generally denominated inlocal foreign currencies. Although foreign currency translation gains andlosses have been immaterial to date, fluctuations in exchange rates between theU.S. Dollar and other currencies could have a material adverse effect on ourbusiness, financial condition or results of operations, and particularly on ouroperating margins. To date, we have minimally sought to hedge the risksassociated with fluctuations in exchange rates, but we may more activelyundertake to do so in the future. Any hedging techniques we implement in thefuture may not be successful. Exchange rate fluctuations could also make ourproducts more expensive than competitive products not subject to thesefluctuations, which could adversely affect our revenues and profitability ininternational 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****DELAY INACCEPTANCE OF OUR PRODUCTS IN THE MARKET**

 

       Our products, including components supplied by others, maycontain errors or defects, especially when first introduced or when newversions are released. Despite internal product testing, we have in the pastdiscovered software errors in some of our products after their introduction.Errors in new products or releases could be found after commencement ofcommercial shipments, and this could result in additional development costs,diversion of technical and other resources from our other development efforts,or the loss of credibility with current or future end-user customers. This couldresult in a loss of revenue or delay in market acceptance of our products,which could have a material adverse effect on our business, financial conditionor results of operations.

 

       Our license agreements with our end-user customers typicallycontain provisions designed to limit our exposure to potential productliability and some contract claims. However, not all of these agreementscontain these types of provisions and, where present, these provisions vary asto their terms and may not be effective under the laws of some jurisdictions. Aproduct liability, warranty, or other claim brought against us could have amaterial adverse effect on our business, financial condition or results ofoperations.

 

       Because our solution currently consists of our softwarerunning on a Windows NT® server and voice processing boards, it is inherentlymore prone to performance interruptions for our end-user customers thantraditional non-software based products. Performance interruptions at ourend-user customer sites, most of which currently do not have back-up systems,could affect demand for our products or give rise to claims against us.

 

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

 

Successful implementation of our growth strategy mayrequire continued access to capital. If we do not generate sufficient cash fromoperations, our growth could be limited unless we are able to obtain capitalthrough additional debt or equity financings. We cannot assure you that debt orequity financings will be available as required for acquisitions or otherneeds. Even if financing is available, it may not be on terms that arefavorable to us or sufficient for our needs. If we are unable to obtainsufficient financing, we may be unable to fully implement our growth strategy.

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

Our stock price has been and could continue to behighly volatile due to a number of factors, including:

•         actualor anticipated fluctuations in our operating results;

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

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

 

•         technologicalinnovations by others;

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

•         the low number of our shares typicallytraded in any trading session;

•         the availability for future sale, orsales, of a substantial number of shares of our common stock in the publicmarket; and

•         generalmarket or economic conditions.

This risk may be heightened because our industry is new and evolving,characterized by rapid technological change and susceptible to the introductionof new competing technologies or competitors.

In addition, the stock market has experiencedsignificant price and volume fluctuations that have particularly affected thetrading prices of equity securities of many technology companies, including us.These price and volume fluctuations often have been unrelated to the operatingperformance of the affected companies. In the past, following periods ofvolatility in the market price of a company’s securities, securities classaction litigation has often been instituted against that company. This type oflitigation, regardless of the outcome, could result in substantial costs and adiversion of management’s attention and resources, which could materially andadversely affect our business, financial condition or results of operations.

**Item3. Qualitative and Quantitative Disclosures about Market Risk.**

 

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

 

We manage our interestrate risk by maintaining an investment portfolio with debt instruments of highcredit quality and relatively short average maturities. We also manage interestrate risk by maintaining sufficient cash and cash equivalent balances such thatwe are typically able to hold our investments to maturity.

 

 

**P**ART II. OTHER INFORMATION

 

**Item1. Legal Proceedings.**

 

        See Note5 of our Notes to the Condensed Consolidated Financial Statements for adescription of correspondence received by us from competitors claiming that ourproducts utilize technologies pioneered and patented by them.

 

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

**Item2. Changes in Securities and Use of Proceeds.**

 

*Salesof Unregistered Securities During the Quarter*

        None.

* *

*Use of Proceeds*

 

        The shares of our common stock issued inthe initial public offering were registered on a Registration Statement on FormS-1 (Registration No. 333-79509) which was declared effective on September 22,1999.  From the effective date of suchRegistration Statement to September 30, 2001, the proceeds generated by ourinitial public offering have been used as described in our report on Form 10-Qfor the quarter ended September 30, 1999 and in addition approximately $19.1million has been used for working capital.

 

**Item 5.Other Information**

 

        Board member Michael P. Cullinane hasresigned from our Board of Directors and related committees.  Mr. Cullinane is the Chief Financial Officerof divine, Inc. which acquired a company with a product that competes with ourInteraction DialerÔ product.  The acquisition closed in earlyNovember.  As a result, Mr. Cullinaneresigned from our Board of Directors and related committees.  In addition, Dr. Jon Anton, D.Sc., resignedfrom our Board of Directors and related committees due to time constraints.

 

        At the Board of Directors meeting onNovember 13, 2001, the remaining Board members elected Mr. Phillip A. Bounsalland Dr. Samuel F. Hulbert to fill the vacancies created by the resignations ofMr. Cullinane and Dr. Anton.  Mr.Bounsall is the Chief Financial Officer of Brightpoint, Inc., a provider ofoutsourced services in the global wireless telecommunications industry and dataindustry.  Dr. Hulbert is President ofRose Hulman Institute of Technology, an engineering, science and math college locatedin Terre Haute, Indiana.

 

        In October 2001, the Company acquiredfrom Donald E. Brown, M.D. (the Company’s founder and CEO) and Robert A.Compton (a director of the Compnay), the 81% ownership of Interactive Portal,Inc., not owned by the Company.  Thepurchase price was based on the net book value of Interactive Portal.  The Company issued as aggregate of 99,136shares of its common stock to Messrs. Brown and Compton as payment of thepurchase price.  Messrs. Brown andCompton are also entitled to royalties (aggregating 5%) for a period of threeyears on sales of the Company’s Service Interaction CenterTM and CommunitéTMproducts, which utilize software developed by Interactive Portal.

 

 

**Item6. Exhibits and Reports on Form 8-K.**

 

(a)   Exhibits

                None.

 

(b)   Reports on Form 8-K

        No reports on Form 8-K were filed during the quarter coveredby this Form 10-Q.

 

 

 

**SIGNATURES**

 

Pursuant to the requirements of the SecuritiesExchange Act of 1934, the Registrant has duly caused this report to be signedon its behalf by the undersigned thereunto duly authorized.

 

InteractiveIntelligence, Inc.

(Registrant)

 
| Date: November 14, 2001 | By  | /s/ Keith A. Midkiff                                       |
|-------------------------|----------|------------------------------------------------------------|
|                    |     |                                                       |
|                    |     | Keith A. Midkiff                                           |
|                    |     | Interim Chief Financial Officer                            |
|                    |     | (Principal Financial Officer and Duly Authorized  Officer) |