UNITED STATES


SECURITIES AND EXCHANGE COMMISSION


Washington, D.C.  20549





____________





FORM 10-Q





(Mark One)





R
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934





For the quarterly period ended March 31, 2010





Or





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





For the transition period from ____________to____________





Commission File Number: 000-27385








INTERACTIVE INTELLIGENCE, INC.


(Exact name of registrant as specified in its charter)





Indiana

(State or other jurisdiction

of incorporation or organization)

35-1933097

(I.R.S. Employer

Identification No.)7601 Interactive Way

Indianapolis, IN 46278

(Address of principal executive offices, including zip code)(317) 872-3000

(Registrant’s telephone number, including area code)Not Applicable(Former name, former address and former fiscal year, if changed since last report)








Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.


Yes     R
No       ̈


Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).




Yes      ̈
No       ̈





Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check One):





Large accelerated filer
*


Accelerated filer
RNon-accelerated filer
*(Do not check if a smaller reporting company)
Smaller reporting company
*





Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).Yes*NoR





As of April 30, 2010, there were 17,445,110 shares outstanding of the registrant’s common stock, $0.01 par value.
















TABLE OF CONTENTS





PART I. FINANCIAL INFORMATION

PageItem 1.
Financial Statements.Condensed Consolidated Balance Sheets as of March 31, 2010 and December 31, 2009

1Condensed Consolidated Statements of Income for the Three Months Ended March 31, 2010 and 2009

2Condensed Consolidated Statement of Shareholders’ Equity for the Three Months Ended March 31, 2010

3Condensed Consolidated Statements of Cash Flows for the Three Months Ended March 31, 2010 and 2009

4Notes to Condensed Consolidated Financial Statements

5Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations.

10Item 3.
Quantitative and Qualitative Disclosures About Market Risk.

17Item 4.
Controls and Procedures.

18PART II. OTHER INFORMATIONItem 1.
Legal Proceedings.

18Item 1A.
Risk Factors.

18Item 6.
Exhibits.

18SIGNATURE

19


i


PART I. FINANCIAL INFORMATION





Item 1. Condensed Consolidated Financial Statements and Notes to Condensed Consolidated Financial Statements.





Interactive Intelligence, Inc.


Condensed Consolidated Balance Sheets


As of March 31, 2010 and December 31, 2009


(In thousands, except share and per share amounts)





March 31,

2010


December 31,

2009Assets

(unaudited)Current assets:Cash and cash equivalents

$
49,679


$
48,497Short-term investments


21,721



16,482Accounts receivable, net of allowance for doubtful accounts of

$1,287 at March 31, 2010 and $1,094 at December 31, 2009


26,982



32,092Deferred tax assets, net


5,808



5,808Prepaid expenses


6,322



5,976Other current assets


3,982



3,935Total current assets


114,494



112,790Property and equipment, net


8,482



8,499Deferred tax assets, net


6,655



6,505Other assets, net


4,792



4,874Total assets

$
134,423


$
132,668Liabilities and Shareholders’ EquityCurrent liabilities:Accounts payable and accrued liabilities

$
10,823


$
11,903Accrued compensation and related expenses


3,642



4,946Deferred product revenues


4,990



5,567Deferred services revenues


36,835



36,225Total current liabilities


56,290



58,641Deferred revenue


5,558



6,420Total liabilities


61,848



65,061Commitments and contingencies (Note 7)


--



--Shareholders’ equity:Preferred stock, no par value: 10,000,000 shares authorized; no shares issued and outstanding


--



--Common stock, $0.01 par value; 100,000,000 shares authorized; 17,389,352 issued and outstanding at March 31, 2010, 17,276,990 issued and outstanding at December 31, 2009


174



173Treasury stock, at cost: 703,512 shares as of March 31, 2010, 815,875 shares as of December 31, 2009


(5,312
)


(6,242
)Additional paid-in capital


95,120



92,815Accumulated deficit


(17,407
)


(19,139
)Total shareholders’ equity


72,575



67,607Total liabilities and shareholders’ equity

$
134,423


$
132,668





See Accompanying Notes to Condensed Consolidated Financial Statements


1


Interactive Intelligence, Inc.
 Condensed Consolidated Statements of Income (unaudited)
 For the Three Months Ended March 31, 2010 and 2009
 (In thousands, except per share amounts)
 
 Three Months Ended

March 31,2010


2009(Note 1)Revenues:Product

$
15,687


$
13,050Services


19,336



16,426Total revenues


35,023



29,476Cost of revenues:Product


4,799



3,528Services


5,597



3,502Total cost of revenues


10,396



9,030Gross profit


24,627



20,446Operating expenses:Sales and marketing


10,352



9,214Research and development


6,425



5,626General and administrative


3,861



3,189Total operating expenses


20,638



18,029Operating income


3,989



2,417Other income (expense):Interest income, net


42



108Other income (expense)


(775
)


(424
)Total other income (expense)


(733
)


(316
)Income before income taxes


3,256



2,101Income tax expense


1,388



878Net income

$
1,868


$
1,223Net income per share:Basic

$
0.11


$
0.07Diluted


0.10



0.07Shares used to compute net income per share:Basic


17,320



16,948Diluted


18,708



17,635


See Accompanying Notes to Condensed Consolidated Financial Statements


2


Interactive Intelligence, Inc.
 Condensed Consolidated Statement of Shareholders’ Equity (unaudited)
 For the Three Months Ended March 31, 2010
 (In thousands)
 
 Common Stock


Additional

Paid-in


Treasury


AccumulatedShares


Amount


Capital


Stock


Deficit


TotalBalances, December 31, 2009


17,277


$
173


$
92,815


$
(6,242
)

$
(19,139
)

$
67,607Stock-based compensation


--



--



1,012



--



--



1,012Exercise of stock options


104



1



(24
)


858



(144
)


691Issuances of common stock


8



--



78



72



8



158Tax benefits from stock-based payment arrangements


--



--



1,251



--



--



1,251Comprehensive income:Net income


--



--



--



--



1,868



1,868Net unrealized investment gain


--



--



(12
)


--



--



(12
)Total comprehensive income


--



--



(12
)


--



1,868



1,856Balances, March 31, 2010


17,389


$
174


$
95,120


$
(5,312
)

$
(17,407
)

$
72,575


See Accompanying Notes to Condensed Consolidated Financial Statements


3


Interactive Intelligence, Inc.
 Condensed Consolidated Statements of Cash Flows (unaudited)
 For Three Months Ended March 31, 2010 and 2009
 (In thousands)
 
 Three Months Ended

March 31,2010


2009Operating activities:Net income

$
1,868


$
1,223Adjustments to reconcile net income to net cash  provided by operating activities:Depreciation


1,030



1,055Stock-based compensation expense


1,012



847Tax benefits from stock-based payment arrangements


(1,251
)


--Deferred income tax


(150
)


670Accretion of investment income


27



5Changes in operating assets and liabilities:Accounts receivable


5,110



4,215Prepaid expenses


(346
)


443Other current assets


(47
)


(817
)Other assets


82



72Accounts payable and accrued liabilities


143



(1,251
)Accrued compensation and related expenses


(1,304
)


(957
)Deferred product revenues


(615
)


(413
)Deferred services revenues


(214
)


(682
)Net cash provided by operating activities


5,345



4,410Investing activities:Sales of available-for-sale investments


2,550



7,800Purchases of available-for-sale investments


(7,828
)


(897
)Purchases of property and equipment


(985
)


(266
)Unrealized loss on investment


--



(2)Net cash (used in) provided by investing activities


(6,263
)


6,635Financing activities:Proceeds from stock options exercised


691



111Proceeds from issuance of common stock


158



69Tax benefits from stock-based payment arrangements


1,251



--Net cash provided by financing activities


2,100



180Net increase in cash and cash equivalents


1,182



11,225Cash and cash equivalents, beginning of year


48,497



34,705Cash and cash equivalents, end of year

$
49,679


$
45,930Cash paid during the year for:Interest

$
1


$
--Income taxes


318



150Other non-cash item:Purchase of property and equipment payable at end of period

$
57


$
51


See Accompanying Notes to Condensed Consolidated Financial Statements


4


Interactive Intelligence, Inc.


Notes to Condensed Consolidated Financial Statements


March 31, 2010 and 2009 (unaudited)





1.
FINANCIAL STATEMENT PRESENTATION




The accompanying unaudited condensed consolidated financial statements of Interactive Intelligence, Inc. (the “Company”) have been prepared in conformity with accounting principles generally accepted in the United States of America (“U.S. GAAP”) and with the instructions for Form 10-Q and Article 10 of Regulation S-X for interim financial information. Accordingly, certain information and note disclosures normally included in the Company’s financial statements prepared in accordance with U.S. GAAP have been condensed, or omitted, pursuant to the rules and regulations of the United States Securities and Exchange Commission (the “SEC”).





The preparation of the Company’s condensed consolidated financial statements requires management to make estimates and assumptions that affect reported amounts of assets and liabilities, at the respective balance sheet dates, and the reported amounts of revenues and expenses during the respective reporting periods. Despite management’s best effort to establish good faith estimates and assumptions, actual results could differ from these estimates. In management’s opinion, the Company’s accompanying condensed consolidated financial statements include all adjustments necessary (which are of a normal and recurring nature, except as otherwise noted) for the fair presentation of the results of the interim periods presented.





The Company’s accompanying condensed consolidated financial statements as of December 31, 2009 have been derived from the Company’s audited consolidated financial statements at that date but do not include all of the information and notes required by U.S. GAAP for complete financial statements. These accompanying condensed consolidated financial statements should be read in conjunction with the Company’s audited consolidated financial statements for the year ended December 31, 2009, included in the Company’s most recent Annual Report on Form 10-K as filed with the SEC on March 16, 2010. The Company’s results of operations for any interim period are not necessarily indicative of the results of operations for any other interim period or for a full fiscal year.





Principles of Consolidation




The accompanying condensed consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries after elimination of all significant intercompany accounts and transactions.





Reclassifications and Adjustments





Effective April 1, 2009, the Company began presenting gains and losses resulting from foreign currency fluctuations within other income, net. Previously, the Company included a portion of these gains and losses within operating expense. The Company changed its presentation as such gains and losses arising from the adjustment of foreign currency fluctuations are incidental to its operations. The Company reclassified $126,000 of foreign currency losses for the three months ended March 31, 2009 from operating expense to other income, net on the accompanying condensed consolidated statements of income. This reclassification did not have any impact on the overall results previously reported.





2.
SUMMARY OF CERTAIN ACCOUNTING POLICIES AND RECENT ACCOUNTING PRONOUNCEMENTS





The Company’s interim critical accounting policies and estimates include the recognition of income taxes using an estimated annual effective tax rate.  For a complete summary of the Company’s other significant accounting policies and other critical accounting estimates, refer to Note 2 of Notes to Consolidated Financial Statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2009.





During the three months ended March 31, 2010, there were no material changes to the Company’s significant accounting policies or critical accounting estimates.





In May 2009, the Financial Accounting Standards Board (“FASB”) established guidance under FASB Accounting Standards Codification (“ASC”) Topic 855, Subsequent Events, which establishes general standards of accounting for and disclosure of events that occur after the balance sheet date but before financial statements are issued or are available to be issued.This guidance became effective for interim and annual reporting periods ending after June 15, 2009.  In February 2010, the FASB amended this guidance under Accounting Standard Update (“ASU”) 2010-09, Amendments to Certain Recognition and Disclosure Requirements.The amended guidance removed the requirement for SEC filers to disclose the date through which an entity has evaluated subsequent events and was effective upon issuance.




In September 2009, the FASB issued FASB ASU 2009-13, Multiple-Deliverable Revenue Arrangements, which addresses criteria for separating consideration in multiple-element arrangements. The guidance requires companies allocating the overall consideration to each deliverable to use an estimated selling price of individual deliverables in the arrangement in the absence of vendor-specific objective evidence or other third-party evidence of the selling price for the deliverables. This guidance will be effective for fiscal years beginning on or after June 15, 2010 and early adoption is permitted. The Company anticipates adopting this guidance on January 1, 2011 and has not determined the effect that the adoption of this guidance will have on its condensed consolidated financial statements.
 
 In September 2009, the FASB issued FASB ASU 2009-14, Certain Revenue Arrangements that Include Software Elements, which excludes from the scope of the FASB’s software revenue guidance tangible products that contain both software and non-software components that function together to deliver a product’s essential functionality. This guidance will be effective prospectively for revenue arrangements entered into or materially modified in fiscal years beginning on or after June 15, 2010 with early adoption permitted. If a company chooses to early adopt this guidance and the adoption is not at the beginning of its fiscal year, the requirements must be applied retrospectively to the beginning of the fiscal year. The Company anticipates adopting this guidance on January 1, 2011 and has not determined the effect that the adoption of this guidance will have on its condensed consolidated financial statements.
 5




In January 2010, the FASB issued FASB ASU 2010-06, Improving Disclosures About Fair Value Measurements,which amends FASB ASC Topic 820, Fair Value Measurements and Disclosures (“FASB ASC 820”). The updated guidance requires new disclosures about recurring or nonrecurring fair-value measurements including significant transfers into and out of Level 1 and Level 2 fair-value measurements and information on purchases, sales, issuances, and settlements on a gross basis in the reconciliation of Level 3 fair-value measurements. For additional detail describing each of the three levels, see Note 3 below. The guidance also clarified existing fair-value measurement disclosure guidance about the level of disaggregation, inputs, and valuation techniques. The guidance became effective for interim and annual reporting periods beginning on or after December 15, 2009, with an exception for the disclosures of purchases, sales, issuances and settlements on the roll-forward of activity in Level 3 fair-value measurements. Those disclosures will be effective for fiscal years beginning after December 15, 2010 and for interim periods within those fiscal years. Upon adopting this guidance, there was no material impact on the Company’s condensed consolidated financial statements.


3.
FAIR VALUE MEASUREMENTS




FASB ASC 820, as amended, defines fair value as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. FASB ASC 820 also establishes a fair value hierarchy which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The standard describes the following three levels of inputs that may be used to measure fair value:
 
 ·
Level 1 - Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities.
 
 ·
Level 2 - Observable inputs other than Level 1 prices such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities.
 
 ·
Level 3 - Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities.
 
 The Company’s assets that are measured at fair value on a recurring basis are generally classified within Level 1 or Level 2 of the fair value hierarchy.  The types of instruments valued based on quoted market prices in active markets include mostly money market securities and equity investments.  Such instruments are generally classified within Level 1 of the fair value hierarchy.  The Company invests in money market funds that are traded daily and does not adjust the quoted price for such instruments.  The types of instruments valued based on quoted prices in less active markets, broker or dealer quotations, or alternative pricing sources with reasonable levels of price transparency include corporate notes, commercial paper and certificates of deposits.  Such instruments are generally classified within Level 2 of the fair value hierarchy.  The Company uses consensus pricing, which is based on multiple pricing sources, to value its fixed income investments.
 
 The following table sets forth a summary of the Company’s financial assets, classified as cash and cash equivalents and short-term investments on its condensed consolidated balance sheet, measured at fair value on a recurring basis as of March 31, 2010 (in thousands):
 Fair Value Measurements at

Reporting Date UsingDescription

Total


Quoted Prices in

Active Markets for

Identical Assets

(Level 1)


Significant

Other Observable

Inputs

(Level 2)


Significant

Unobservable

Inputs

(Level 3)Cash & cash equivalents:Money Market Funds

$
19,189


$
19,189


$
--


$
--Short-term investments:Commercial Paper

$
4,246


$
--


$
4,246


$
--Agency Bonds


4,891



--



4,891



--Corporate Notes


6,196



--



6,196



--T-Bills


6,388



--



6,388



--Total

$
21,721


$
--


$
21,721


$
--
 4.
NET INCOME PER SHARE





Basic net income per share is calculated based on the weighted-average number of common shares outstanding in accordance with FASB ASC Topic 260, Earnings per Share. Diluted net income per share is calculated based on the weighted-average number of common shares outstanding plus the effect of dilutive potential common shares. When the Company reports net income, the calculation of diluted net income per share excludes shares underlying stock options outstanding that would be anti-dilutive. Potential common shares are composed of shares of common stock issuable upon the exercise of stock options. The following table sets forth the calculation of basic and diluted net income per share (in thousands, except per share amounts):


Three Months Ended

March 31,2010


2009Net income, as reported (A)

$
1,868


$
1,223Weighted-average outstanding shares of common stock (B)


17,320



16,948Dilutive effect of stock options


1,388



687Common stock and common stock equivalents (C)


18,708



17,635Net income per share:Basic (A/B)

$
0.11


$
0.07Diluted (A/C)


0.10



0.07
 6





The Company’s calculation of diluted net income per share for the three months ended March 31, 2010 and 2009 excludes stock options to purchase approximately 796,000 and 1.8 million shares of the Company’s common stock, respectively, as their effect would be anti-dilutive.


5.
STOCK-BASED COMPENSATION


Stock Option Plans





The Company’s Stock Option Plans, adopted in 1995, 1999 and 2006, authorize the Board of Directors or the Compensation Committee, as applicable, to grant incentive and nonqualified stock options, and, in the case of the 2006 Equity Incentive Plan, as amended (the “2006 Plan”), stock appreciation rights, restricted stock, restricted stock units, performance shares, performance units and other stock-based awards. After adoption of the 2006 Plan by the Company’s shareholders in May 2006, the Company may no longer make any grants under previous plans, but any shares subject to awards under the 1999 Stock Option and Incentive Plan and the Outside Directors Stock Option Plan (collectively, the “1999 Plans”) that are cancelled are added to shares available under the 2006 Plan. A maximum of 5,850,933 shares are available for delivery under the 2006 Plan, which consists of (i) 2,150,000 shares, plus (ii) 320,000 shares available for issuance under the 1999 Plans, but not underlying any outstanding stock options or other awards under the 1999 Plans, plus (iii) up to 3,380,933 shares subject to outstanding stock options or other awards under the 1999 Plans that expire, are forfeited or otherwise terminate unexercised on or after May 18, 2006. The number of shares available under the 2006 Plan is subject to adjustment for certain changes in the Company’s capital structure. The exercise price of options granted under the 2006 Plan is equal to the closing price of the Company’s common stock, as reported by The NASDAQ Global Select Market, on the business day immediately preceding the date of grant. During the first quarter of 2010, the Company’s Board of Directors approved an increase of 1,200,000 shares available for grant under the 2006 Plan, which increase is subject to shareholder approval at the Company’s Annual Meeting of Shareholders to be held on May 20, 2010.





Stock options granted by the Company are categorized into three types. The first type of stock options granted by the Company to employees and newly-elected non-employee directors is non-performance-based stock options that are subject only to time-based vesting.  These stock options vest in four equal annual installments beginning one year after the grant date.  The fair value of these option grants is determined on the date of grant and the related compensation expense is recognized for the entire award on a straight-line basis over the vesting period.





The second type is performance-based stock options that are subject to cancellation if the specified performance targets are not met.  If the applicable performance targets have been achieved, the options will vest in four equal annual installments beginning one year after the performance-related period has ended.  The fair value of these stock option grants is determined on the date of grant and the related compensation expense is recognized over the requisite service period, including the initial period for which the specified performance targets must be met.




Commencing in May 2009, the Company began granting its non-employee directors options annually that are similar to the non-performance-based options described above except the director options vest one year after the grant date (“annual director options”). The fair value of these annual director option grants is determined on the date of the grant and the related compensation expense is recognized over one year. Prior to May 2009, non-employee directors received non-performance-based stock options that vested over four years.


The plans may be terminated by the Company’s Board of Directors at any time.





Stock-Based Compensation Expense Information





The following table summarizes the allocation of stock-based compensation expense related to employee and director stock options under FASB ASC Topic 718, Compensation – Stock Compensation for the three months ended March 31, 2010 and 2009 (in thousands):





Three Months Ended

March 31,2010


2009Stock-based compensation expense by category:Cost of services

$
79


$
65Sales and marketing


324



308Research and development


298



245General and administrative


311



229Total stock-based compensation expense

$
1,012


$
847


7


Valuation Assumptions


The Company estimated the fair value of stock options using the Black-Scholes valuation model. There were no material changes in the way the assumptions were calculated as previously disclosed in the Company’s Annual Report on Form 10-K for the year ended December 31, 2009.  There were no annual director options granted during the three months ended March 31, 2010 and 2009. The weighted-average estimated per option value of non-performance-based and performance-based options granted during the three months ended March 31, 2010 and 2009 used the following assumptions:


Three Months Ended

March 31,Valuation assumptions for non-performance-based options:

2010


2009Dividend yield


--
%


--
%Expected volatility


69.10
%


67.88
%Risk-free interest rate


2.06
%


1.64
%Expected life of option (in years)

4.25 years


4.25 years
 
 Prior to May 2009, directors were granted options that vested over four years. The fair value of these options was estimated using the non-performance-based option valuation assumptions set forth above.
  Three Months Ended

March 31,Valuation assumptions for performance-based options:

2010


2009Dividend yield


--
%


--
%Expected volatility


67.81
%


67.35
%Risk-free interest rate


2.30
%


1.77
%Expected life of option (in years)

4.75 years


4.75 years


Stock Option Activity





The following table sets forth a summary of option activity for the three months ended March 31, 2010:




As of March 31, 2010Options


Weighted-

Average

Exercise

PriceBalances, beginning of year


3,425,743


$
9.36Options granted


521,500



19.66Options exercised


(103,832
)


6.65Options cancelled, forfeited or expired


(1,750
)


33.44Options outstanding


3,841,661



10.78Option price range

$
2.51 - $43.88Weighted-average fair value of options granted

$
10.71Options exercisable


2,470,121


$
8.58Options available for grant


393,794




6.
CONCENTRATION OF CREDIT RISK




One partner accounted for 10% of the Company’s accounts receivable as of March 31, 2010 and the same partner accounted for 13% of the Company’s accounts receivable as of December 31, 2009. No customer or partner accounted for 10% or more of the Company’s revenues for the three months ended March 31, 2010 and 2009, and no country other than the United States accounted for more than 10% of the Company's revenues in either period.
 7.
COMMITMENTS AND CONTINGENCIES
  Legal Proceedings
  From time to time, the Company is involved in certain legal proceedings in the ordinary course of conducting its business, including but not limited to infringement of proprietary rights claims by competitors and other technology providers. While the ultimate liability pursuant to these actions cannot currently be determined, the Company believes these legal proceedings will not have a material adverse effect on its financial position or results of operations. Litigation in general, and intellectual property litigation in particular, can be expensive and disruptive to normal business operations.
 8





Guarantees




The Company provides indemnifications of varying scope and amounts to certain customers against claims of intellectual property infringement made by third parties arising from the use of its products. The Company’s software license agreements, in accordance with FASB ASC Topic 460, Guarantees, include certain provisions for indemnifying customers, in material compliance with their license agreement, against liabilities if the Company’s software products infringe upon a third party's intellectual property rights, over the life of the agreement. The Company is not able to estimate the potential exposure related to the indemnification provisions of its license agreements but has not incurred expenses under these indemnification provisions.The Company may at any time and at its option and expense:  (i) procure the right of the customer to continue to use the Company’s software that may infringe a third party’s rights; (ii) modify its software so as to avoid infringement; or (iii) require the customer to return its software and refund the customer the fee actually paid by the customer for its software less depreciation based on a five-year straight-line depreciation schedule. The customer’s failure to provide timely notice or reasonable assistance will relieve the Company of its obligations under this indemnification to the extent that it has been actually and materially prejudiced by such failure. To date, the Company has not incurred, nor does it expect to incur, any material related costs and, therefore, has not reserved for such liabilities.
 The Company’s software license agreements also include a warranty that its software products will substantially conform to its software user documentation for a period of one year, provided the customer is in material compliance with the software license agreement. To date, the Company has not incurred any material costs associated with these product warranties, and as such, has not reserved for any such warranty liabilities.
 
 Lease Commitments and Other Contingencies
 
 The Company leases space for its world headquarters in Indianapolis, Indiana under an operating lease agreement and amendments which expire on March 31, 2018. The Company also has multiple leases for offices and other space throughout the world. The office space for sales, services, development and international offices are rented under month-to-month leases. In accordance with FASB ASC Topic 840, Leases, rental expense is recognized ratably over the lease period, including those leases containing escalation clauses.


Other Contingencies





The Company has received and may continue to receive certain payroll tax credits and real estate tax abatements that were granted to the Company based upon certain growth projections.  If the Company’s actual results are less than those projections, the Company may be subject to repayment of some or all of the tax credits or payment of additional real estate taxes in the case of the abatements.  The Company does not believe that it will be subject to payment of any money related to these taxes; however, the Company cannot provide assurance as to the outcome.


8.
INCOME TAXES
  The following table sets forth the items accounting for the difference between expected income tax benefit (expense) at the 35% federal statutory rate compared to actual income tax benefit (expense) recorded in the Company’s condensed consolidated financial statements (in thousands):
 Three Months Ended

March 31,2010


2009Expected income tax expense at 35% tax rate

$
(1,139
)

$
(735
)State taxes, net of federal benefit


(237
)


(116
)Stock-based compensation expense related to non-deductible stock option expense


(99
)


(140
)Research tax credit


--



63Disqualifying dispositions


80



--Other


7



50Income tax benefit (expense)

$
(1,388
)

$
(878
)
 
 FASB ASC Topic 740, Income Taxes, prescribes a recognition threshold and measurement attributes for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return.  The Company has identified an uncertain tax position related to certain tax credits that the Company currently believes meets the “more likely than not” recognition threshold to be sustained upon examination. Prior to the fourth quarter of 2007, this uncertain tax position had not been recognized because the Company had a full valuation allowance established.  The balance of the reserve was approximately $910,000 at December 31, 2009. As of March 31, 2010, the reserve had not changed.
 
 The Company and its subsidiaries file federal income tax returns and income tax returns in various states and foreign jurisdictions.  Tax years 2006 and forward remain open for examination for federal tax purposes and tax years 2005 and forward remain open for examination for the Company’s more significant state tax jurisdictions.  To the extent utilized in future years’ tax returns, net operating loss and capital loss carryforwards at December 31, 2009 will remain subject to examination until the respective tax year is closed.


9




During 2009, the Company utilized its remaining net operating loss deferred tax asset generated in prior years and began utilizing operating losses generated from the exercise of stock options. The Company does not have a deferred tax asset on its balance sheet for the tax benefits from these deductions, and the reduction in taxes payable related to the use of these deductions is recorded as a credit to additional paid-in capital. At March 31, 2010, the Company had approximately $8.1 million in stock-based compensation deductions available to offset taxable income and $5.9 million of alternative minimum tax, federal and state research tax credit carryforwards and foreign tax credits available to offset taxes payable.
 Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations.
  The following Management’s Discussion and Analysis of Financial Condition and Results of Operations is intended to provide our investors with an understanding of our past performance, our financial condition and our prospects and should be read in conjunction with other sections of this Quarterly Report on Form 10-Q. Investors should carefully review the information contained in this report under Part II, Item 1A “Risk Factors” and in the Part I, Item 1A “Risk Factors” section of our Annual Report on Form 10-K for the fiscal year ended December 31, 2009. The following will be discussed and analyzed:
 
 ·
Forward-Looking Information
 
 ·
Overview
 
 ·
Financial Highlights
 
 ·
Historical Results of Operations
 ·
Comparison of Three Months Ended March 31, 2010 and 2009
 ·
Liquidity and Capital Resources
 
 ·
Critical Accounting Policies and Estimates
 
 Forward-Looking Information
 Certain statements in this Quarterly Report on Form 10-Q contain “forward-looking” information (as defined in the Private Securities Litigation Reform Act of 1995,Section 27A of the Securities Act of 1933, as amended and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) that involves risks and uncertainties which may cause actual results to differ materially from those predicted in the forward-looking statements. Forward-looking statements can often be identified by their use of such verbs as “expects”, “anticipates”, “believes”, “intend”, “plan”, “may”, “should”, “will”, “would”, “will be”, “will continue”, “will likely result”, or similar verbs or conjugations of such verbs. If any of our assumptions on which the statements are based prove incorrect or should unanticipated circumstances arise, our actual results could materially differ from those anticipated by such forward-looking statements. The differences could be caused by a number of factors or combination of factors, including, but not limited to, unstable economic conditions, rapid technological changes in the industry, our ability to maintain profitability, to manage successfully our growth, to manage successfully our increasingly complex third-party relationships resulting from the software and hardware components being licensed or sold with our solutions, to maintain successful relationships with certain suppliers which may be impacted by competition in the technology industry, to maintain successful relationships with our current and any new partners, to maintain and improve our current products, to develop new products, to protect our proprietary rights adequately, to successfully integrate acquired businesses and other factors set forth in our Securities and Exchange Commission (“SEC”) filings.
 
 Overview
 
 Interactive Intelligence, Inc. (“Interactive Intelligence”, “we”, “us” or “our”) was formed in 1994 as an Indiana corporation and maintains its world headquarters and executive offices at 7601 Interactive Way, Indianapolis, IN 46278. Our telephone number is (317) 872-3000. We are located on the web at http://www.inin.com. We file annual, quarterly and current reports, proxy statements and other documents with the SEC under the Exchange Act. These periodic and current reports and all amendments to those reports are available free of charge on the investor relations page of our website at http://investors.inin.com.
  We are a leading provider of software application suites for Voice over Internet Protocol (“VoIP”) business communications and are increasingly leveraging our leadership position in the worldwide contact center market to offer our solutions to enterprises. Businesses and organizations, including those that employ remote and mobile workers, utilize our solutions in industries including, but not limited to, teleservices, financial services (banks, credit unions, accounts receivable management), insurance, higher education, healthcare, retail, technology, government and business services. Our innovative software products and services are designed for:
 
 ·
Multichannel contact management and business communications (voice and messaging) using the Session Initiation Protocol (“SIP”) global communications standard that supports VoIP;
 
 ·
Business process automation (“BPA”) using a communications-based approach; and
 
 ·
Content management, including document as well as workflow management.
 
 With our single software platform, organizations can replace various traditional “multipoint” communications products. Our solutions incorporate a full-featured media server, media gateways, SIP proxy, and SIP station voice device for Internet Protocol (“IP”)-based communications networks and infrastructures. Customers can deploy our solutions on-premises or in a Communications as a Service (“CaaS”) model using a hosted data center.
 Our solutions integrate with business systems and end-user devices, enhance the mobility of today’s remote workforce, scale to thousands of users, manage content in large volumes, provide communications and data security, and satisfy a range of business communications and interaction management needs for:
 10
 ·
The Contact Center
  ·
Enterprise IP Telephony
  ·
Business Process Automation
  By implementing our all-in-one solutions, businesses are able to unify multichannel communications media (phone, fax, e-mail, web chat, content) and information, automate business processes, enhance workforce performance and productivity, improve customer service processes, and readily adapt to changing market and customer requirements.Contact centers can leverage our platform to support thousands of agents, including remote “Work-at-Home” agents, and handle inbound, outbound and “blended” inbound/outbound interactions, at one location or throughout multi-site contact center operations. Our enterprise IP telephony solutions provide call control and messaging for mid- and large-sized business enterprises with 100 to several hundred thousand users, with the ability to scale user counts up or down as needed. Enterprises, contact centers, and other organizations can utilize our BPA solutions to automate processes using an approach that incorporates communications functionality such as routing, quality monitoring, and the ability to indicate employee availability.
 
 For further information on our business and the products and services we offer, refer to the Part I, Item 1 “Business” section of our Annual Report on Form 10-K for the year ended December 31, 2009.
 
 Our management monitors certain key measures to assess our financial results. In particular, we track trends on product orders, contracted professional services, and CaaS orders from quarter to quarter and in comparison to the prior year actual results and current year plan amounts. We also review leading market indicators to look for trends in economic conditions. As noted below, macroeconomic conditions have materially affected the orders we received in certain of our recent quarters. In addition to orders and revenues, management reviews costs of revenue and operating expenses including staffing levels which affect salaries, our largest expense, to ensure we are managing new expenditures and controlling costs. For additional discussions regarding trends and our expectations for 2010, see “Financial Highlights” beginning on page 12.
 
 In addition to the above, our management monitors diluted earnings per share (“EPS”), which is a key measure of performance that is also used by analysts and investors, on both a GAAP and non-GAAP basis. Management uses non-GAAP EPS, net income and operating income, which exclude non-cash stock option and non-cash income tax expense, to analyze our business. These measures are not in accordance with, or an alternative for, GAAP and may be different from non-GAAP measures used by other companies. Stock-based compensation expense is non-cash and income tax expense is primarily non-cash. We believe that the presentation of non-GAAP results, when shown in conjunction with corresponding GAAP measures, provides useful information to our management and investors regarding financial and business trends related to our results of operations. Further, our management believes that these non-GAAP measures improve management’s and investors’ ability to compare our financial performance with other companies in the technology industry. Because stock-based compensation expense and non-cash income tax expense amounts can vary significantly between companies, it is useful to compare results excluding these amounts. Our management also uses financial statements that exclude stock-based compensation expense related to stock options and non-cash income tax expense for our internal budgets.
 Reconciliations of these non-GAAP measures to the most directly comparable GAAP measures are included below (in thousands, except per share amounts):
  Three Months Ended

March 31,2010


2009Net income, as reported

$
1,868


$
1,223Non-cash stock-based compensation expense:Cost of services


79



65Sales and marketing


324



308Research and development


298



245General and administrative


311



229Total


1,012



847Non-cash income tax expense


1,241



799Non-GAAP net income

$
4,121


$
2,869Operating income, as reported

$
3,989


$
2,417Non-cash stock-based compensation expense


1,012



847Non-GAAP operating income

$
5,001


$
3,264Diluted EPS, as reported

$
0.10


$
0.07Non-cash stock-based compensation expense


0.05



0.05Non-cash income tax expense


0.07



0.04Non-GAAP diluted EPS

$
0.22


$
0.16
 11
 Financial Highlights
 The table below shows our total revenues (in millions) for the most recent five quarters and the years ended December 31, 2009, 2008 and 2007 and the percentage change over the previous period.
 
 Period

Revenues


Sequential

Growth %Three Months Ended:March 31, 2010

$
35.0



(3
)%December 31, 2009


35.9



8
%September 30, 2009


33.2



1
%June 30, 2009


32.9



12
%March 31, 2009


29.5



(6
)%Year Ended December 31:2009

$
131.4



8
%2008


121.4



102007


109.9



32
 For the three months ended March 31, 2010, our revenues increased by 19% and our net income increased by 53% compared to the same period in 2009. Consistent with historical trends, our revenues declined sequentially from the fourth quarter of 2009 to the first quarter of 2010. Factors affecting our revenue performance in any particular year include macroeconomic conditions, customer budget constraints and seasonal buying patterns, the availability of personnel to implement our solutions, and willingness of customers to implement critical telecommunications systems. Revenues in any particular period can greatly fluctuate from other periods. We continue to see signs of economic recovery including more willingness from prospective customers to commit to new capital purchases compared to a year ago. We believe that we are experiencing shorter sales cycles and growing pipelines.
 Product revenues increased by $2.6 million during the three months ended March 31, 2010 compared to the same period in 2009 primarily due to a 35% increase in the dollar amount of product orders from both new and existing customers across all three of the major geographies in which we operate. Services revenues increased by $2.9 million during the three months ended March 31, 2010 compared to the three months ended March 31, 2009 primarily due to increased maintenance and support fees and increased CaaS revenues. We believe our CaaS services revenues and related expenses will continue growing as more customers utilize hosted delivery of software for their information technology.
 
 Cost of products increased by $1.3 million during the three months ended March 31, 2010 compared to the same period in 2009 primarily as a result of an increase in hardware costs. Total operating expenses increased by $2.6 million, or 14%, during the three months ended March 31, 2010 compared to the three months ended March 31, 2009 primarily due to increases in compensation expense as staffing increased in all departments. Other income (expense) increased by $351,000 during the three months ended March 31, 2010 compared to the same period in 2009 as a result of fluctuations in exchange rates.
 Historical Results of Operations
 
 The following table presents certain financial data, derived from our unaudited statements of income, as a percentage of total revenues for the periods indicated. The operating results for the three months ended March 31, 2010 and 2009 are not necessarily indicative of the results that may be expected for the full year or for any future period.
  Three Months Ended

March 31,2010


2009Revenues:Product


45
%


44
%Services


55



56Total revenues


100



100Cost of revenues:Product


14



12Services


16



19Total cost of revenues


30



31Gross profit


70



69Operating expenses:Sales and marketing


30



31Research and development


18



19General and administrative


11



11Total operating expenses


59



61Operating income


11



8Other income (expense):Interest income, net


--



--Other income (expense), net


(2
)


(1
)Total other income (expense)


(2
)


(1
)Income before income taxes


9



7Income tax expense


(4
)


(3
)Net income


5
%


4
%
 12
 
 Comparison of Three Months Ended March 31, 2010 and 2009
 
 Revenues
 
 Primary Sources of Revenues
 We generate revenues from: (i) product revenues, which include licensing the right to use our software applications and, in certain instances, selling hardware as a part of our solutions; and (ii) services revenues, which include support fees from perpetual license agreements, renewal fees from annually renewable license agreements, professional services fees, educational services fees, and fees from our CaaS offering. Our revenues are generated by direct sales to customers and through our partner channel.
 Product Revenues

Three Months Ended

March 31,2010


2009($ in thousands)Product revenues

$
15,687


$
13,050Change from prior year period


20
%


(12
)%Percentage of total revenues


45
%


44
%
 
 Not all software and hardware product orders are recognized as revenues when they are received because of certain contractual terms or the collection history with particular customers or partners. Consequently, product revenues for any particular period not only reflect orders received in the current period but also orders received in previous periods and recognized in the current period. In addition, product orders include first year support, which is deferred and recognized over the support period.
  Product revenues increased by $2.6 million during the three months ended March 31, 2010 compared to the same period in 2009 primarily due to a 35% increase in the dollar amount of orders from both new and existing customers. The increase in orders was experienced in all three major geographies in which we operate. During the first quarter of 2010, we received two orders that were greater than $1.0 million and ten orders greater than $250,000 compared to no orders greater than $1.0 million and nine orders greater than $250,000 during the same period in 2009. We continue to see signs of economic recovery as evidenced by our strong order growth year-over-year.
 During the fourth quarter of 2009, we received one order from our partner channel which is expected to generate product revenues greater than $2.9 million in 2010. During the first quarter of 2010, we recognized $1.8 million in product revenues, including $617,000 related to hardware revenue, and anticipate recognizing $1.1 million during the remainder of 2010.
 Product revenues can fluctuate from period to period depending on the mix of contracts sold between perpetual licenses and annually renewable licenses. While the majority of our product licenses are perpetual, we have certain customers, whose original license contracts were signed prior to 2004, with renewable term licenses. Generally, orders for perpetual licenses result in a significant portion of the contract value being recognized when received if recognition criteria are satisfied, while renewable term licenses are recognized ratably over the term of the agreement, generally one year. Perpetual license orders, which typically have a significant portion of the revenue recognized immediately, were 89% of total product orders during the first quarter of 2010 compared to 83% during the first quarter of 2009. The impact of the mix of contracts on our product revenues occurs only in the year of a product order; subsequent renewal fees received for annually renewable licenses and renewal support fees for perpetual contracts are all allocated entirely to services revenues.
 Services Revenues

Three Months Ended

March 31,2010


2009($ in thousands)Services revenues

$
19,336


$
16,426Change from prior year period


18
%


12
%Percentage of total revenues


55
%


56
%
 
 Services revenues include the portion of license arrangements allocated to maintenance and support from annually renewable and perpetual contracts, renewals of annually renewable licenses and maintenance contracts, and revenues from professional services, CaaS and education. Revenues related to our renewal and support fees represented approximately 75% and 76% our total services revenues for the three months ended March 31, 2010 and 2009, respectively.
  Services revenues increased by $2.9 million during the three months ended March 31, 2010 compared to the same period in 2009, primarily due to increased maintenance and support fees of $2.0 million resulting from continued growth in our installed base of customers. We believe our installed base of customers and resulting revenues will continue to grow. In addition, CaaS revenues increased $528,000 or 64% for the three months ended March 31, 2010 compared to the same period in 2009. We received one CaaS order greater than $1.0 million and three CaaS orders greater than $250,000 in the first quarter of 2010. The revenues from these orders will be recognized ratably over the life of the CaaS contract, which is typically three to four years. As a result, our unrecognized CaaS revenues have continued to increase as we have signed new CaaS contracts. This amount of unrecognized revenues totaled more than $6.3 million as of March 31, 2010 and was not included in deferred revenue. Although some costs related to CaaS are fixed, others are variable based on usage and call volume, and therefore, we would expect our services expenses to increase as the revenues from these orders are recognized over the next three to four years. We believe our CaaS services revenues will continue growing as more customers utilize hosted delivery of software for their information technology needs instead of licensing software and purchasing hardware and hiring additional technical employees.
 13
 Services revenues have and will fluctuate based on dollar amount of orders and license renewals, the number of attendees at our educational classes, the amount of assistance our customers and partners need for implementation and installation and CaaS adoption. The actual percentage fee charged for renewal of annually renewable licenses and perpetual support agreements as compared to the initial annually renewable license fee and perpetual license, respectively, is comparable on a relative percentage basis, and therefore, the mix of these types of contracts in the future is not expected to impact our future services revenues. Renewal rates for license and support fees in the first quarter of 2010 were consistent with prior periods.
 Cost of Revenues

Three Months Ended

March 31,2010


2009($ in thousands)Cost of revenues:Product

$
4,799


$
3,528Services


5,597



5,502Total cost of revenues

$
10,396


$
9,030Change from prior year period


15
%


--
%Product cost as a % of product gross revenues


31
%


27
%Services cost as a % of services gross revenues


29
%


33
%
  Cost of product consist of hardware costs (including media servers and Interaction Gateway appliances that we develop, as well as servers, telephone handsets and gateways that we purchase and resell), royalties for third-party software and other technologies included in our solutions, personnel costs and product distribution facility costs. Cost of product can fluctuate depending on which software applications are licensed to our customers and partners, the third-party software that is licensed by the end-user from us as part of our software applications and the dollar amount of orders for hardware and appliances.
  Cost of product increased $1.3 million during the three months ended March 31, 2010 compared to the same period in 2009, primarily as a result of an increase in hardware costs as more customers purchased our hardware offerings to implement their solutions.
 Cost of services consist primarily of compensation expenses for technical support, professional services and educational personnel as well as costs associated with our CaaS offering. Cost of services increased by $95,000 during the three months ended March 31, 2010 compared to the same period in 2009, primarily due to increased compensation expense of $211,000 resulting from additions to our services staff and growth in CaaS expenses of $298,000 related to data center and associated hosting costs. Partially offsetting these increases were decreases in expenses related to employee incentives and reductions in compensation expense for professional services personnel, as more set-up costs are being amortized as CaaS implementations grow. CaaS implementation fees are deferred and recognized ratably over the life of the CaaS contract.
 Gross Profit

Three Months Ended

March 31,2010


2009($ in thousands)Gross profit

$
24,627


$
20,446Change from prior year period


20
%


--
%Percentage of total revenues


70
%


69
%
 
 Gross profit as a percentage of total revenues in any particular period reflects the amount of product and services revenues recognized and cost of product and services incurred.
  Gross profit increased by $4.2 million during the quarter ended March 31, 2010 compared to the same period in 2009 primarily due to a greater percentage increase in product and services revenues compared to the increase in cost of product and services, for the reasons set forth above.
 Operating Expenses
 
 Sales and Marketing

Three Months Ended

March 31,2010


2009($ in thousands)Sales and marketing expenses

$
10,352


$
9,214Change from prior year period


12
%


(10
)%Percentage of total revenues


30
%


31
%Percentage of net product revenues


95
%


97
%
 14
 Sales and marketing expenses primarily include compensation, travel, and promotional costs related to our sales, marketing and channel management operations. These expenses increased $1.1 million during the three months ended March 31, 2010 compared to the same period in 2009, primarily due to an increase in compensation expenses of $995,000 as sales and marketing staffing increased by 9% from a year ago, and higher promotional costs. We expect marketing costs to continue to increase throughout 2010 as we expand our promotional efforts.
 Research and Development

Three Months Ended

March 31,2010


2009($ in thousands)Research and development expenses

$
6,425


$
5,626Change from prior year period


14
%


13
%Percentage of total revenues


18
%


19
%
  Research and development expenses are comprised primarily of compensation and depreciation expenses. These expenses increased by $799,000 during the three months ended March 31, 2010 compared to the same period in 2009, primarily due to an increase in compensation expense of $770,000 resulting from an 18% increase in research and development staffing. This increase included staff at AcroSoft Corporation, which we acquired in the second quarter of 2009.
 
 We believe that investment in research and development is critical to our future growth, particularly because our competitive position in the marketplace is directly related to the timely development of new and enhanced solutions that are essential to our business. As a result, we expect the dollar amount of research and development expenses will continue to increase in future periods.
 General and Administrative

Three Months Ended

March 31,2010


2009($ in thousands)General and administrative expenses

$
3,861


$
3,189Change from prior year period


21
%


(19
)%Percentage of total revenues


11
%


11
%
 
 General and administrative expenses include salary and incentive compensation expense as well as general corporate expenses that are not allocable to other departments, such as legal and other professional fees and bad debt expense.
 General and administrative expenses increased by $672,000 during the three months ended March 31, 2010 compared to the same period in 2009. This increase was primarily due to increases in compensation expense of $234,000 related to staff additions and a reduction in the forfeiture rate assumption that we used to calculate the expense during the third quarter of 2009, and bad debt expense of $184,000.
 Other Income (Expense)
 
 Interest Income, Net
  Three Months Ended

March 31,2010


2009($ in thousands)Cash, cash equivalents and short-term investments (average)

$
68,190


$
47,671Interest income, gross


42



108Return on investments


0.3
%


0.9
%
 
 Interest income, net, primarily consists of interest earned from investments and interest-bearing cash accounts. Interest expense and fees, which are not material for any years reported, are also included in this category.
  Interest earned on investments decreased during the three months ended March 31, 2010 compared to the three months ended March 31, 2009, as a result of lower interest rates from decreasing interest yields on investments. During the first quarter of 2010, we held the majority of our liquid investments in money market funds that are secured by low risk government securities.
 We continue to monitor the allocation of funds in which we have invested to maximize our return on investment while utilizing safe investment alternatives within our established investment policy. We do not have any investments in subprime assets.
 15
 Other Income (Expense)

Three Months Ended

March 31,2010


2009($ in thousands)Other income (expense)

$
(775
)

$
(424
)
  Other income (expense) includes foreign currency transaction gains and losses. These gains and losses can fluctuate based on the amount of revenue that is generated in certain international currencies (particularly the Euro), the exchange gain or loss that results from foreign currency disbursements and receipts, and the cash balances and exchange rates at the end of a reporting period. Other expense during the three months ended March 31, 2010 and 2009 included $770,000 and $424,000, respectively, of foreign currency losses. The expense from both quarters reflects the weakening of the Euro and British Pound in relation to the U.S. dollar. We had a portion of our cash balances in Euro deposit accounts and received collections from some of our customers in Euros and British Pounds. During February 2010, we transferred the majority of our Euro cash balances to a U.S. dollar account. The volatility of exchange rate changes and our increasing balances outstanding overseas have resulted in us exploring ways to better hedge against fluctuations in the future, but no hedging strategy was implemented as of March 31, 2010. By reducing the cash held in non-U.S. dollar accounts, we have reduced the future impact of foreign exchange fluctuations.
 Income Tax Benefit (Expense)

Three Months Ended

March 31,2010


2009($ in thousands)Income tax benefit (expense)

$
(1,388
)

$
(878
)
  For the period ended March 31, 2010, $147,000 of our income tax expense is expected to result in cash payments for state and foreign taxes and the remaining amount will be offset by the utilization of our net operating losses. We have significant remaining credits and losses to offset taxable income and taxes payable as described in Note 8 of Notes to Condensed Consolidated Financial Statements in Part I, Item 1 of this Quarterly Report on Form 10-Q. Our effective tax rate was 42.6% for the quarter ended March 31, 2010. The tax rate is determined by considering the federal tax rate, rates in various states and international jurisdictions in which we have operations, and a portion of the amount of stock-based compensation that is not deductible for income tax purposes.
 Liquidity and Capital Resources
  We generate cash from the collections related to licensing our products as well as from selling hardware, renewals of annual licenses and maintenance and support agreements, and the delivery of other services.  During the first quarter of 2010, we also received $691,000 in cash from employees exercising stock options and $158,000 from purchases of common stock under our 2000 Employee Stock Purchase Plan. We use cash primarily for paying our employees (including salaries, commissions and benefits), leasing office space, paying travel expenses, marketing activities, paying vendors for hardware, other services and supplies, and purchasing property and equipment. We expect our capital expenditures to total approximately $3.0 million for 2010 due to furniture and equipment purchases for our increasing number of staff, the addition of new offices and employee on-site dining at our world headquarters. We continue to be debt free.
 We determine liquidity by combining cash and cash equivalents and short-term investments as shown in the table below. Based on our recent performance and current expectations, we believe that our current liquidity position, when combined with our anticipated cash flows from operations, will be sufficient to satisfy our working capital needs and current or expected obligations associated with our operations over the next 12 months. Our future requirements will depend on many factors, including cash flows from operations, territory expansion and product development decisions and potential acquisitions. If our liquidity is not sufficient to cover our needs, we may be forced to raise additional capital, either through the capital markets or debt financings, and may not be able to do so on favorable terms or at all.
  March 31,

2010


December 31,

2009($ in thousands)Cash and cash equivalents

$
49,679


$
48,497Short-term investments


21,721



16,482Total liquidity

$
71,400


$
64,979
 
 The amount that we report as cash and cash equivalents or as short-term investments fluctuates depending on investing decisions in each period. Purchases of short-term investments and property and equipment are reported as a use of cash and the related receipt of proceeds upon maturity of investments is reported as a source of cash.
 
 The following table shows cash flows from operating activities, investing activities and financing activities for the stated periods:
 Three Months Ended

March 31,2010


2009Beginning cash and cash equivalents

$
48,497


$
34,705Cash provided by operating activities


5,345



4,410Cash provided by (used in) investing activities


(6,263
)


6,635Cash provided by financing activities


2,100



180Ending cash and cash equivalents

$
49,679


$
45,930
 16
 Cash provided by operating activities during both quarters was generated primarily by our profitability net of ordinary fluctuations in our operating assets and liabilities. The cash used in investing activities during the three months ended March 31, 2010 increased as we began to transfer a small portion of our cash to short-term investments as the rates improved. Cash provided by financing activities during both quarters was due to proceeds from stock options exercised, and for the quarter ended March 31, 2010, was due to tax benefits from stock-based compensation.
 
 Contractual Obligations
 
 As of March 31, 2010, we had additional purchase obligations totaling $297,000 to be paid out over the next year related to the build-out of on-site employee dining at our world headquarters. There have been no other material changes to our contractual obligations as set forth in the Contractual Obligations table disclosed in our Annual Report on Form 10-K for the year ended December 31, 2009.
  Off-Balance Sheet Arrangements
 Except as set forth in the Contractual Obligations table disclosed in our Annual Report on Form 10-K for the year ended December 31, 2009, we have no off-balance sheet arrangements that have or are reasonably likely to have a current or future material impact on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources as of March 31, 2010.
 
 We provide indemnifications of varying scope and amount to certain customers against claims of intellectual property infringement made by third parties arising from the use of our products.Our software license agreements, in accordance with FASB ASC Topic 460, Guarantees, include certain provisions for indemnifying customers, in material compliance with their license agreement, against liabilities if our software products infringe upon a third party's intellectual property rights, over the life of the agreement. We are not able to estimate the potential exposure related to the indemnification provisions of our license agreements but have not incurred expenses under these indemnification provisions. We may at any time and at our option and expense:  (i) procure the right of the customer to continue to use our software that may infringe a third party’s rights; (ii) modify our software so as to avoid infringement; or (iii) require the customer to return our software and refund the customer the fee actually paid by the customer for our software less depreciation based on a five-year straight-line depreciation schedule. The customer’s failure to provide timely notice or reasonable assistance will relieve us of our obligations under this indemnification to the extent that we have been actually and materially prejudiced by such failure. To date, we have not incurred, nor do we expect to incur, any material related costs and, therefore, have not reserved for such liabilities.
 Our software license agreements also include a warranty that our software products will substantially conform to our software user documentation for a period of one year, provided the customer is in material compliance with the software license agreement. To date, we have not incurred any material costs associated with these product warranties, and as such, we have not reserved for any such warranty liabilities in our operating results.
  Critical Accounting Policies and Estimates
 
 The preparation of our condensed consolidated financial statements requires us to make estimates and judgments that affect the reported amount of assets, liabilities, revenues and expenses. Actual results may differ from those estimates and judgments under different assumptions or conditions. We have discussed the critical accounting policies that we believe affect our more significant estimates and judgments used in the preparation of our consolidated financial statements in the “Management’s Discussion and Analysis of Financial Condition and Results of the Operations—Critical Accounting Policies and Estimates” section of our Annual Report on Form 10-K for the year ended December 31, 2009 and in Note 2 of Notes to Consolidated Financial Statements included in our Annual Report on Form 10-K for the year ended December 31, 2009. For a further summary of certain accounting policies, see Note 2 of Notes to Condensed Consolidated Financial Statements included in Part I, Item 1 of this Quarterly Report on Form 10-Q.
  Item 3.
Quantitative and Qualitative Disclosures about Market Risk.
 
 We develop software application products in the United States and license our products worldwide. As a result, our financial results could be affected by market risks, including changes in foreign currency exchange rates, interest rates or weak economic conditions in certain markets. Market risk is the potential of loss arising from unfavorable changes in market rates and prices.
 
 Foreign Currency Exchange Rates
  We transact business in certain foreign currencies including the British Pound and the Euro. However, as a majority of the orders we receive are denominated in U.S. dollars, a strengthening of the U.S. dollar could make our products more expensive and less competitive in foreign markets. We have not historically used foreign currency options or forward contracts to hedge our currency exposures because of variability in the timing of cash flows associated with our larger contracts. We did not have any such hedge instruments in place at March 31, 2010. Rather, we attempt to mitigate our foreign currency risk by generally transacting business and paying salaries in the functional currency of each of the major countries in which we do business, thus creating natural hedges. Additionally, as our business matures in foreign markets, we may offer our products and services in certain other local currencies. If this were to occur, foreign currency fluctuations would have a greater impact on us and may have an adverse effect on our results of operations. For the three months ended March 31, 2010, our foreign currency transaction losses amounted to $775,000.
 
 As of March 31, 2010 and December 31, 2009, we had accounts with Euro balances of approximately $4.5 million and $14.6 million, respectively, British Pound balances of $85,000 and $289,000, respectively, and balances of seven other foreign currencies totaling $450,000 and $371,000, respectively. During the first quarter of 2010, we converted the majority of our Euro and British Pound balances back to U.S. dollars in order to mitigate foreign currency risk.
 Interest Rate Risk
 
 We invest cash balances in excess of operating requirements in securities that have maturities of one year or less. The carrying value of these securities approximates market value, and there is no long-term interest rate risk associated with these investments.
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 Item 4.
Controls and Procedures.
 
 We maintain a set of disclosure controls and procedures that are designed to ensure that information required to be disclosed by us in the reports filed by us under the Exchange Act is (a) recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and (b) accumulated and communicated to our management, including our principal executive and principal financial officers, to allow timely decisions regarding required disclosures. We carried out an evaluation, under the supervision and with the participation of our management, including our President and Chief Executive Officer (principal executive officer) and our Chief Financial Officer (principal financial officer), of the effectiveness of the design and operation of our disclosure controls and procedures as of March 31, 2010, pursuant to Rule 13a-15 of the Exchange Act. Based on that evaluation, our President and Chief Executive Officer and our Chief Financial Officer concluded that our disclosure controls and procedures were effective as of March 31, 2010.
 
 There have been no changes in our internal control over financial reporting that occurred during the quarter ended March 31, 2010 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
 
 PART II. OTHER INFORMATION
 
 Item 1.
Legal Proceedings.
 
 The information set forth under “Legal Proceedings” in Note 7 of Notes to Condensed Consolidated Financial Statements included in Part I, Item 1 of this Quarterly Report on Form 10-Q is incorporated herein by reference.
 
 Item 1A.
Risk Factors.
 
 In addition to the information set forth in this Quarterly Report on Form 10-Q and before deciding to invest in, or retain, shares of our common stock, you also should carefully review and consider the information contained in our other reports and periodic filings that we make with the SEC, including, without limitation, the information contained under the caption Part I, Item 1A “Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2009. Those risk factors could materially affect our business, financial condition and results of operations.
 
 The risks that we describe in our public filings are not the only risks that we face. Additional risks and uncertainties not currently known to us, or that we presently deem to be immaterial, also may materially adversely affect our business, financial condition and results of operations. There have been no material changes from the risk factors previously disclosed in our Annual Report on Form 10-K for the year ended December 31, 2009.
  Item 6.
Exhibits.
 
 (a)
Exhibits
  Incorporated by ReferenceExhibit Number
Exhibit Description

Form


Exhibit

Filing Date

Filed Herewith3.1

Restated Articles of Incorporation of the Company, as currently in effect

S-1

(Registration No. 333-79509)



3.1

5/28/19993.2

Amended By-Laws of the Company, as currently in effect


8-K



3.2

7/28/200910.38

Form of Non-Employee Director Change of Control Agreement dated March 29, 2010 by and between Interactive Intelligence, Inc. and Richard G. Halperin


10-Q



10.38

8/9/200731.1

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











X31.2

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











X32.1

Certification of the Chief Executive Officer, pursuant to 18 U. S. C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002











X32.2

Certification of the Chief Financial Officer, pursuant to 18 U. S. C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002











X
  18
  SIGNATURE
 
 Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned hereunto duly authorized.
 
 Interactive Intelligence, Inc.

(Registrant)Date:   May 10, 2010



By:

/s/     Stephen R. HeadStephen R. Head

Chief Financial Officer,

Vice President of Finance and Administration,

Secretary and Treasurer

(Principal Financial Officer and Principal Accounting Officer)
 19