**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

 

**Washington,D.C. 20549**

 

----

 

**FORM 10-Q**

 

**(Mark One)**

 
| **ý** | ** ** | **QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE  ACT OF 1934**                                                                                              |
|------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|       |       |                                                                                                                                                                                                 |
|       |       | **For the  quarterly period ended June 30, 2005**                                                                                                                                               |
|       |       |                                                                                                                                                                                                 |
|       |       | **Or**                                                                                                                                                                                               |
|       |       |                                                                                                                                                                                                 |
| **o**      | ** ** | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE  ACT OF 1934**                                                                                             |
|       |       |                                                                                                                                                                                                 |
|       |       | **For the  transition period from              to               ** |

 

**CommissionFile Number 000-27385**

 

**INTERACTIVE INTELLIGENCE, INC.**

(Exact name ofregistrant as specified in its charter)

 

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

 

**7601Interactive Way**

**Indianapolis,Indiana 46278**

(Address ofprincipal executive offices)

 

**(317) 872-3000**

(Registrant’stelephone number)

 

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

 
| Yes o        No  ý |   |   |
|-----------------------------------------------------------------|--------|--------|

 

Indicate bycheck mark whether the registrant is an accelerated filer (as defined in Rule 12b-2of the Exchange Act).

 
| Yes o        No  ý |   |   |
|-----------------------------------------------------------------|--------|--------|

 

The number ofshares of common stock outstanding on July 31, 2005 was 16,044,305.

 

 

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TABLE OFCONTENTS

 
| PART I. FINANCIAL INFORMATION |                                                                                                            |
|------------------------------------|-----------------------------------------------------------------------------------------------------------------|
|                               |                                                                                                            |
| Item 1.                            | Condensed Consolidated Balance Sheets as of  June 30, 2005 and December 31, 2004                      |   |
|                               |                                                                                                            |   |
|                               | Condensed Consolidated Statements of Operations for the three and six  months ended June 30, 2005 and 2004 |   |
|                               |                                                                                                            |   |
|                               | Condensed Consolidated Statement of Shareholders’ Equity for the six  months ended June 30, 2005      |   |
|                               |                                                                                                            |   |
|                               | Condensed Consolidated Statements of Cash Flows for the six months  ended June 30, 2005 and 2004           |   |
|                               |                                                                                                            |   |
|                               | Notes to Condensed Consolidated Financial Statements                                                            |   |
|                               |                                                                                                            |   |
| Item 2.                            | Management’s Discussion and Analysis of Financial Condition and  Results of Operations                     |   |
|                               |                                                                                                            |   |
| Item 3.                            | Quantitative and Qualitative Disclosures About Market Risk                                                      |   |
|                               |                                                                                                            |   |
| Item 4.                            | Controls and Procedures                                                                                         |   |
|                               |                                                                                                            |
| PART II.  OTHER INFORMATION   |                                                                                                            |
|                               |                                                                                                            |
| Item  1.                           | Legal  Proceedings                                                                                              |   |
|                               |                                                                                                            |   |
| Item 4.                            | Submission of Matters to a Vote of Security Holders                                                             |   |
|                               |                                                                                                            |   |
| Item  6.                           | Exhibits                                                                                                        |   |
|                               |                                                                                                            |
| SIGNATURES                         |                                                                                                            |

 

2

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**PART I. FINANCIAL INFORMATION**

 

**Item 1. Condensed Consolidated FinancialStatements and Footnotes.**

 

**InteractiveIntelligence, Inc.**

**Condensed Consolidated Balance Sheets**

**As of June 30,2005 and December 31, 2004**

**(inthousands, except share amounts)**

 
| ** **                                                                                                                                                                     | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                     | ** ** | **2005**          | ** ** | **2004**              | ** ** |
| ** **                                                                                                                                                                     | ** ** | **(unaudited)**   | ** ** | **(Note 1)**          | ** ** |
| **Assets**                                                                                                                                                                     |       |              |       |                  |       |
| Current  assets:                                                                                                                                                               |       |              |       |                  |       |
| Cash and  cash equivalents                                                                                                                                                     |       | $                 | 13,639     |                  | $          | 14,603 |   |
| Accounts  receivable, net of allowance for doubtful accounts of $556 in 2005 and $410  in 2004                                                                                 |       | 13,210            |       | 10,251                |       |
| Prepaid  expenses                                                                                                                                                              |       | 2,130             |       | 2,119                 |       |
| Other  current assets                                                                                                                                                          |       | 689               |       | 836                   |       |
| Total  current assets                                                                                                                                                          |       | 29,668            |       | 27,809                |       |
| Property and  equipment, net                                                                                                                                                   |       | 4,155             |       | 4,071                 |       |
| Other  assets, net                                                                                                                                                             |       | 654               |       | 618                   |       |
| Total assets                                                                                                                                                                   |       | $                 | 34,477     |                  | $          | 32,498 |   |
|                                                                                                                                                                           |       |              |       |                  |       |
| **Liabilities  and Shareholders’ Equity**                                                                                                                                 |       |              |       |                  |       |
| Current  liabilities:                                                                                                                                                          |       |              |       |                  |       |
| Line of  credit                                                                                                                                                                |       | $                 | 3,000      |                  | $          | 3,000 |   |
| Accounts  payable and accrued liabilities                                                                                                                                      |       | 4,956             |       | 5,894                 |       |
| Accrued  compensation and related expenses                                                                                                                                     |       | 1,390             |       | 1,200                 |       |
| Deferred  product revenues                                                                                                                                                     |       | 4,477             |       | 4,484                 |       |
| Deferred  services revenues                                                                                                                                                    |       | 14,916            |       | 12,884                |       |
| Total current  liabilities                                                                                                                                                     |       | 28,739            |       | 27,462                |       |
| 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; 16,029,287 issued and  outstanding at June 30, 2005, 15,926,594 issued and outstanding at December 31,  2004 |       | 160               |       | 159                   |       |
| Additional  paid-in capital                                                                                                                                                    |       | 65,565            |       | 65,179                |       |
| Accumulated  deficit                                                                                                                                                           |       | (59,987           | )          | (60,302               | )          |
| Total  shareholders’ equity                                                                                                                                               |       | 5,738             |       | 5,036                 |       |
| Total  liabilities and shareholders’ equity                                                                                                                               |       | $                 | 34,477     |                  | $          | 32,498 |   |

 

See Accompanying Notes toCondensed Consolidated Financial Statements

 

3

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**InteractiveIntelligence, Inc.**

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

**For the Threeand Six Months Ended June 30, 2005 and 2004**

**(inthousands, except per share amounts)**

 
| ** **                                    | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|-----------------------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                                    | ** ** | **June 30,**      | ** ** | **June 30,**    | ** ** |
| ** **                                    | ** ** | **2005**               | ** ** | **2004**             | ** ** | **2005** | ** ** | **2004** | ** ** |
| Revenues:                                     |       |                   |       |                 |       |   |   |   |   |
| Product                                       |       | $                      | 8,596      |                 | $          | 7,261 |   | $ | 16,482 |   | $ | 14,356 |   |
| Services                                      |       | 7,026                  |       | 6,380                |       | 13,733 |   | 12,991 |   |
| Total  revenues                               |       | 15,622                 |       | 13,641               |       | 30,215 |   | 27,347 |   |
| Cost of  revenues:                            |       |                   |       |                 |       |   |   |   |   |
| Product                                       |       | 1,108                  |       | 404                  |       | 1,874 |   | 999 |   |
| Services                                      |       | 2,703                  |       | 2,771                |       | 5,410 |   | 5,524 |   |
| Total cost  of revenues                       |       | 3,811                  |       | 3,175                |       | 7,284 |   | 6,523 |   |
| Gross profit                                  |       | 11,811                 |       | 10,466               |       | 22,931 |   | 20,824 |   |
| Operating  expenses:                          |       |                   |       |                 |       |   |   |   |   |
| Sales and  marketing                          |       | 6,146                  |       | 5,047                |       | 12,000 |   | 10,064 |   |
| Research and  development                     |       | 3,212                  |       | 3,258                |       | 6,407 |   | 6,536 |   |
| General and  administrative                   |       | 2,035                  |       | 1,776                |       | 4,056 |   | 3,705 |   |
| Restructuring  and other charges              |       | —                 |       | 85                   |       | — |   | 101 |   |
| Total  operating expenses                     |       | 11,393                 |       | 10,166               |       | 22,463 |   | 20,406 |   |
| Operating  income                             |       | 418                    |       | 300                  |       | 468 |   | 418 |   |
| Other income  (expense):                      |       |                   |       |                 |       |   |   |   |   |
| Interest  income, net                         |       | 62                     |       | 25                   |       | 113 |   | 32 |   |
| Other income  (expense)                       |       | (136                   | )          | 25                   |       | (182 | ) | 72 |   |
| Total other  income (expense)                 |       | (74                    | )          | 50                   |       | (69 | ) | 104 |   |
| Income  before income taxes                   |       | 344                    |       | 350                  |       | 399 |   | 522 |   |
| Income taxes                                  |       | 54                     |       | 46                   |       | 84 |   | 98 |   |
| Net income                                    |       | $                      | 290        |                 | $          | 304 |   | $ | 315 |   | $ | 424 |   |
|                                          |       |                   |       |                 |       |   |   |   |   |
| Net income  per share:                        |       |                   |       |                 |       |   |   |   |   |
| Basic                                         |       | $                      | 0.02       |                 | $          | 0.02 |   | $ | 0.02 |   | $ | 0.03 |   |
| Diluted                                       |       | 0.02                   |       | 0.02                 |       | 0.02 |   | 0.03 |   |
|                                          |       |                   |       |                 |       |   |   |   |   |
| Shares used  to compute net income per share: |       |                   |       |                 |       |   |   |   |   |
| Basic                                         |       | 16,015                 |       | 15,845               |       | 15,986 |   | 15,826 |   |
| Diluted                                       |       | 16,685                 |       | 16,735               |       | 16,608 |   | 16,716 |   |

 

See Accompanying Notes toCondensed Consolidated Financial Statements

 

4

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**InteractiveIntelligence, Inc.**

**Condensed Consolidated Statement of Shareholders’ Equity (unaudited)**

**For the SixMonths Ended June 30, 2005**

**(inthousands)**

 
| ** **                        | ** ** | ** **       | ** ** | ** **  | ** ** | **Additional**  | ** ** | ** **  | ** ** | ** ** | ** ** |
|-----------------------------------|------------|------------------|------------|-------------|------------|-----------------|------------|-------------|------------|------------|------------|
| ** **                        | ** ** | **Common Stock** | ** ** | **Paid-in** | ** ** | **Accumulated** | ** ** | ** **  | ** ** |
| ** **                        | ** ** | **Shares**       | ** ** | **Amount**  | ** ** | **Capital**     | ** ** | **Deficit** | ** ** | **Total**  | ** ** |
|                              |       |             |       |        |       |            |       |        |       |       |       |
| Balances, December 31,  2004 |       | 15,927           |       | $           | 159        |            | $          | 65,179      |       | $          | (60,302    | ) | $ | 5,036 |   |
|                              |       |             |       |        |       |            |       |        |       |       |       |
| Issuances of  common stock        |       | 33               |       | —      |       | 111             |       | —      |       | 111        |       |
| Exercise of  stock options        |       | 69               |       | 1           |       | 214             |       | —      |       | 215        |       |
| Stock-based  compensation         |       | —           |       | —      |       | 61              |       | —      |       | 61         |       |
| Net income                        |       | —           |       | —      |       | —          |       | 315         |       | 315        |       |
|                              |       |             |       |        |       |            |       |        |       |       |       |
| Balances, June 30,  2005     |       | 16,029           |       | $           | 160        |            | $          | 65,565      |       | $          | (59,987    | ) | $ | 5,738 |   |

 

See Accompanying Notes toCondensed Consolidated Financial Statements

 

5

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**InteractiveIntelligence, Inc.**

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

**For theSix Months Ended June 30, 2005 and 2004**

**(inthousands)**

 
| ** **                                                                     | ** ** | **Six Months Ended** | ** ** |
|--------------------------------------------------------------------------------|------------|----------------------|------------|
| ** **                                                                     | ** ** | **June 30,**    | ** ** |
| ** **                                                                     | ** ** | **2005**             | ** ** | **2004** | ** ** |
| **Operating  activities:**                                                     |       |                 |       |   |   |
| Net income                                                                     |       | $                    | 315        |   | $ | 424 |   |
| Adjustments  to reconcile net income to net cash used by operating activities: |       |                 |       |   |   |
| Depreciation                                                                   |       | 1,143                |       | 1,670 |   |
| Amortization  of deferred stock-based compensation                             |       | 61                   |       | 10 |   |
| Changes in  operating assets and liabilities:                                  |       |                 |       |   |   |
| Accounts  receivable                                                           |       | (2,959               | )          | 473 |   |
| Prepaid  expenses                                                              |       | (11                  | )          | 46 |   |
| Other  current assets                                                          |       | 147                  |       | 2 |   |
| Other assets                                                                   |       | (36                  | )          | 11 |   |
| Accounts  payable and accrued liabilities                                      |       | (938                 | )          | (54 | ) |
| Accrued  compensation and related expenses                                     |       | 190                  |       | (132 | ) |
| Deferred  product revenues                                                     |       | (7                   | )          | (2,688 | ) |
| Deferred  services revenues                                                    |       | 2,032                |       | (144 | ) |
| Net cash  used by operating activities                                         |       | (63                  | )          | (382 | ) |
|                                                                           |       |                 |       |   |   |
| **Investing  activities:**                                                     |       |                 |       |   |   |
| Purchases of  property and equipment                                           |       | (1,227               | )          | (583 | ) |
| Sales of  available-for-sale investments                                       |       | —               |       | 3,008 |   |
| Net cash  provided (used) by investing activities                              |       | (1,227               | )          | 2,425 |   |
|                                                                           |       |                 |       |   |   |
| **Financing  activities:**                                                     |       |                 |       |   |   |
| Payments on  line of credit, net                                               |       | —               |       | 200 |   |
| Proceeds  from issuance of common stock                                        |       | 111                  |       | 149 |   |
| Proceeds  from stock options exercised                                         |       | 215                  |       | 153 |   |
| Net cash  provided by financing activities                                     |       | 326                  |       | 502 |   |
|                                                                           |       |                 |       |   |   |
| Net increase  (decrease) in cash and cash equivalents                          |       | (964                 | )          | 2,545 |   |
| Cash and  cash equivalents, beginning of period                                |       | 14,603               |       | 12,461 |   |
| Cash and  cash equivalents, end of period                                      |       | $                    | 13,639     |   | $ | 15,006 |   |
|                                                                           |       |                 |       |   |   |
| Cash paid  for interest                                                        |       | $                    | 8          |   | $ | 14 |   |
| Cash paid  for taxes                                                           |       | 180                  |       | 4 |   |

 

See Accompanying Notes toCondensed Consolidated Financial Statements

 

6

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**InteractiveIntelligence, Inc.**

**Notes To Condensed Consolidated Financial Statements**

**June 30,2005 and 2004 (unaudited)**

 

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

 

Interactive Intelligence, Inc. (the “Company”)is a leading provider of software applications for contact centers and isleveraging that leadership position to provide mission critical voice overInternet protocol (VoIP) applications to enterprises. The Company sells intofour distinct markets, all of whose needs are increasing for VoIP-basedsystems:

 

•      Contact Centers,

•      Enterprise IP Telephony,

•      Unified Communications, and

•      Self-service Automation.

 

The Company’s principal competitors arehardware vendors who offer proprietary approaches using a combination of phonesystems, call distributors, voice mail systems, and interactive voice response(IVR) systems equipment. The Company offers a software solution based on MicrosoftWindows that resides on a customer’s network and uses an open SessionInitiation Protocol (SIP) for VoIP networking. This open approach typicallyresults in lower overall costs for phone devices, system maintenance, andcustomer networking. The Company’s software applications are alsopre-integrated to many popular business applications such as financial,customer relationship management (CRM) and enterprise resource planning (ERP)software, thereby automating and tracking business transactions to customerinteractions. The Company is best known for its bundled suite of contact centerapplications that includes multi-media customer contact for phone calls, Webchat, Web callback, e-mail queuing, customer defined queues, and integratedspeech recognition applications.

 

Principal operations of the Company commenced during 1997. Since then,the Company has established wholly-owned subsidiaries in Australia, France, theNetherlands and the United Kingdom, and in 2004 formed its Vonexus subsidiaryfor Global Enterprise IP Telephony and Microsoft small business customermarkets. The Company also currently has branch offices in Canada, Germany, HongKong, Japan, Korea, Malaysia, Singapore and Sweden. The Company markets itssoftware applications in the Americas, Europe, the Middle East and Africa(EMEA), and the Asia Pacific region (APAC).

 

The accompanying unaudited financialstatements have been prepared in conformity with accounting principlesgenerally accepted in the United States of America for interim financialinformation and with the instructions for Form 10-Q and Article 10 ofRegulation S-X. Accordingly, certain information and footnote disclosuresnormally included in financial statements prepared in accordance withaccounting principles generally accepted in the United States of America havebeen condensed, or omitted, pursuant to the rules and regulations of theSecurities and Exchange Commission. In our opinion, the statements include alladjustments necessary (which are of a normal and recurring nature) for the fairpresentation of the results of the interim periods presented.

 

The balance sheet at December 31, 2004has been derived from the audited financial statements at that date but doesnot include all of the information and footnotes required by accountingprinciples generally accepted in the United States of America for completefinancial statements.

 

These financial statements should be read inconjunction with our audited consolidated financial statements for the yearended December 31, 2004, included in the Company’s Form 10-K for theyear ended December 31, 2004, filed with the Securities and ExchangeCommission on March 28, 2005. Our results of operations for any interimperiod are not necessarily indicative of the results of operations for anyother interim period or for a full fiscal year.

 

7

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**2.****     NetIncome Per Common Share**

 

Basic net income per share is calculatedbased on the weighted-average number of outstanding common shares in accordancewith Financial Accounting Standards Board (FASB) Statement No. 128, *Earnings per Share*. Diluted net income per share iscalculated based on the weighted-average number of outstanding common sharesplus the effect of dilutive potential common shares. Potential common sharesare composed of shares of common stock issuable upon the exercise of stockoptions. The calculation of dilutive net income per share excludes sharesunderlying outstanding stock options with exercise prices that exceed theaverage market price of the Company’s common stock for the period, as theeffect would be antidilutive.

 

The following table presents the calculationof basic and diluted net income per share (in thousands, except per shareamounts):

 
| ** **                                               | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|----------------------------------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                                               | ** ** | **June 30,**      | ** ** | **June 30,**    | ** ** |
| ** **                                               | ** ** | **2005**               | ** ** | **2004**             | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                                     |       |                   |       |                 |       |   |   |   |   |
| Net income,  as reported (A)                             |       | $                      | 290        |                 | $          | 304 |   | $ | 315 |   | $ | 424 |   |
|                                                     |       |                   |       |                 |       |   |   |   |   |
| Weighted  average outstanding shares of common stock (B) |       | 16,015                 |       | 15,845               |       | 15,986 |   | 15,826 |   |
| Dilutive  effect of options to purchase common stock     |       | 670                    |       | 890                  |       | 622 |   | 890 |   |
| Common stock  and common stock equivalent shares (C)     |       | 16,685                 |       | 16,735               |       | 16,608 |   | 16,716 |   |
|                                                     |       |                   |       |                 |       |   |   |   |   |
| Net income  per share:                                   |       |                   |       |                 |       |   |   |   |   |
| Basic (A/B)                                              |       | $                      | 0.02       |                 | $          | 0.02 |   | $ | 0.02 |   | $ | 0.03 |   |
| Diluted  (A/C)                                           |       | 0.02                   |       | 0.02                 |       | 0.02 |   | 0.03 |   |

 

The Company’s calculation of diluted netincome per share for the three months ended June 30, 2005 and 2004excludes options to purchase 2.0 million and 1.2 million shares of commonstock, respectively, and diluted net income per share for the six months ended June 30,2005 and 2004 excludes options to purchase 2.2 million and 1.2 million sharesof common stock, respectively, as their effect would be antidilutive.

 

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

 

The Company applies the intrinsic-value-basedmethod of accounting prescribed by Accounting Principles Board (APB) Opinion No. 25,*Accounting for Stock Issued to Employees*,and related interpretations including FASB Interpretation No. 44, *Accounting for Certain Transactions involving Stock Compensation, aninterpretation of APB Opinion No. 25*, to account for itsfixed-plan stock options. Under this method, compensation expense is recordedon the date of grant only if the current market price of the underlying stockexceeds the exercise price. FASB Statement No. 123, *Accounting for Stock-Based Compensation*and FASB Statement No. 148, *Accounting for Stock-Based Compensation – Transitionand Disclosure - an amendment of FASB Statement No. 123*,established accounting and disclosure requirements using a fair-value-basedmethod of accounting for stock-based employee compensation plans. As permittedby existing accounting standards, the Company has elected to continue to applythe intrinsic-value-based method of accounting described above, and has adoptedonly the disclosure requirements of FASB Statements No. 123 and 148. SeeNote 6 below for a discussion of upcoming changes to the accounting forstock-based compensation.

 

8

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For purposesof pro forma disclosures, the estimated fair value of the options is amortizedto expense on a straight-line basis over the options’ vesting period. The tablebelow illustrates the effect on net income (loss) and net income (loss) pershare if the Company had applied the fair value recognition provisions of FASBStatement No. 123 to stock-based employee compensation (in thousandsexcept per share amounts).

 
| ** **                                                                                                                          | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                                                                                                                          | ** ** | **June 30,**      | ** ** | **June 30,**    | ** ** |
| ** **                                                                                                                          | ** ** | **2005**               | ** ** | **2004**             | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                                                                                                                |       |                   |       |                 |       |   |   |   |   |
| Net income,  as reported                                                                                                            |       | $                      | 290        |                 | $          | 304 |   | $ | 315 |   | $ | 424 |   |
| Add:  Stock-based compensation expense included in reported net income, net of  related tax effects                                 |       | 18                     |       | 7                    |       | 61 |   | 10 |   |
| Deduct:  Total stock-based compensation expense determined under fair value based  method for all awards, net of related tax effect |       | (842                   | )          | (855                 | )          | (1,614 | ) | (1,607 | ) |
| Pro forma  net loss                                                                                                                 |       | $                      | (534       | )                    | $          | (544 | ) | $ | (1,238 | ) | $ | (1,173 | ) |
|                                                                                                                                |       |                   |       |                 |       |   |   |   |   |
| Net income  (loss) per share:                                                                                                       |       |                   |       |                 |       |   |   |   |   |
| Basic – as  reported                                                                                                           |       | $                      | 0.02       |                 | $          | 0.02 |   | $ | 0.02 |   | $ | 0.03 |   |
| Diluted – as  reported                                                                                                         |       | $                      | 0.02       |                 | $          | 0.02 |   | $ | 0.02 |   | $ | 0.03 |   |
| Basic – pro  forma                                                                                                             |       | $                      | (0.03      | )                    | $          | (0.03 | ) | $ | (0.08 | ) | $ | (0.07 | ) |
| Diluted –  pro forma                                                                                                           |       | $                      | (0.03      | )                    | $          | (0.03 | ) | $ | (0.08 | ) | $ | (0.07 | ) |

 

**4.****     Reclassifications**

 

During the second quarter of 2005, theCompany reclassified, for prior periods, certain foreign currency transactiongains and losses, as well as foreign tax withholdings, from sales andmarketing, and general and administrative expenses, to other income (expense).These reclassifications had no impact on the Company’s total consolidatedresults in any period presented.

 

**5.****     Concentrationof Credit Risk**

 

No resellers or customershad greater than 10% concentration of accounts receivable as of June 30,2005 or as of December 31, 2004.

 

**6.****     Contingencies**

 

From time to time the Company has receivedclaims from competitors and other technology providers claiming that theCompany’s technology infringes their respective proprietary rights. One suchclaim has resulted in a legal proceeding being filed against the Company, whichis described below. The Company cannot assure you that these matters can beresolved amicably without litigation, or that the Company will be able to enterinto licensing arrangements on terms and conditions that would not have amaterial adverse effect on its business, financial condition or results ofoperations.

 

On January 14, 2005, the Company enteredinto a non-exclusive license agreement with a telecommunication technologyprovider to use certain of its fax-related patents.  Pursuant to this agreement, the Company haspaid initial fees of $300,000 and will pay additional fees of $250,000 in August 2005.  The Company may also pay up to an additional$475,000 in license fees if certain specified criteria are met.

 

On September 30, 2003, RecursionSoftware, Inc. filed suit in Dallas County Court in Dallas, Texas againstthe Company alleging breach of contract and money due under claims of quantummeruit and unjust enrichment. Recursion claims that the Company incorporatedRecursion software into one of its products in breach of the underlyinglicense. On November 3, 2003, the Company had the case removed to FederalDistrict Court in Dallas, Texas and on January 28, 2004, Recursionasserted a copyright infringement claim against the Company, which was expandedin scope on September 10, 2004. No dollar amount has been stated in theaction. The Company believes that it has strong defenses to the claims and

 

9

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intends to vigorously defend against the action. The Company believesthat this matter can be resolved without a material adverse effect on itsbusiness, financial condition or results of operations; however, the Companycannot provide assurance as to the outcome.

 

In November 2002, the Company received anotification from the French government as a result of a tax audit that hadbeen conducted encompassing the years 1998, 1999, 2000 and 2001. Theseassessments claim various taxes are owed related to Value Added Tax (VAT) and corporationtaxes in addition to what has previously been paid and accrued. As of June 30,2005, the assessment related to VAT was approximately $2.8 million and theassessment related to corporation taxes was approximately $364,000. The Company’stax counsel has assessed the possibility of the Company paying the assessmentrelated to VAT as remote and the assessment related to corporation taxes asreasonably possible. The Company has not accrued for these amounts. The Companyis appealing the assessments, but cannot assure you that these matters will beresolved without litigation or that it will not have to pay some or all of theassessments.

 

From time to time, the Company is alsoinvolved in certain legal proceedings in the ordinary course of conducting itsbusiness. While the ultimate liability pursuant to these actions cannotcurrently be determined, the Company believes these legal proceedings will nothave a material adverse effect on its financial position or results ofoperations. Litigation in general, and intellectual property litigation inparticular, can be expensive and disruptive to normal business operations.Moreover, the results of complex legal proceedings are difficult to predict.

 

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

 

In December 2004, theFASB issued FASB Statement No. 123R, *Share-Based Payment*,which establishes standards for transactions in which an entity exchanges itsequity instruments for goods or services. This standard requires a publicentity to measure the cost of employee services received in exchange for anaward of equity instruments based on the grant-date fair value of the award.This eliminates the exception to account for such awards using the intrinsicvalue-based method previously allowable under APB Opinion No. 25 (see Note3 above). In March 2005, the Securities and Exchange Commission (SEC)released Staff Accounting Bulletin (SAB) 107, *Share-BasedPayment*, which expresses views of the SEC staff about theapplication of FASB Statement No. 123R. FASB Statement No. 123R was tobe effective for interim or annual reporting periods beginning on or after June 15,2005, but in April 2005 the SEC issued a rule that FASB Statement No. 123Rwill be effective for annual reporting periods beginning on or after June 15,2005. The Company expects that the adoption will have a significant adverseimpact on its consolidated net income and net income per share.

 

In December 2004, theFASB issued FASB Statement No. 153, *Exchanges of NonmonetaryAssets - an amendment of APB Opinion No. 29 (Accounting for NonmonetaryTransactions)*. FASB Statement No. 153 requires that exchangesof nonmonetary assets be measured based on the fair value of the assetsexchanged. Further, it expands the exception for nonmonetary exchanges ofsimilar productive assets to nonmonetary assets that do not have commercialsubstance. The provisions of FASB Statement No. 153 are effective fornonmonetary asset exchanges occurring in fiscal periods beginning after June 15,2005. The adoption of the provisions of FASB Statement No. 153 is notexpected to have a material impact on the Company’s consolidated financialposition or results of operations.

 

In December 2004, theFASB issued FASB Staff Position No. 109-1 (FAS 109-1), *Application of FASB Statement No. 109,*Accounting forIncome Taxes*, to the Tax Deduction on Qualified ProductionActivities Provided by the American Jobs Creation Act of 2004 (AJCA)*.The AJCA introduces a special phased in tax deduction, starting at 3%, onqualified production activities. FAS 109-1 clarifies that this taxdeduction should be accounted for as a special tax deduction in accordance withFASB Statement No. 109. The Company does not expect the adoption of thesenew tax provisions to have a material impact on its consolidated financialposition, results of operations or cash flows.

 

10

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

 

### **Forward-Looking Information**

 

Certainstatements in this Form 10-Q contain “forward-looking” information (asdefined in Section 27A of the Securities Act of 1933, as amended and Section 21Eof the Securities Exchange Act of 1934, as amended) that involve risks anduncertainties which may cause actual results to differ materially from thosepredicted in the forward-looking statements. Forward-looking statements canoften be identified by their use of such verbs as “expects,” “anticipates,” and“believes” or similar verbs or conjugations of such verbs. If any of ourassumptions on which the statements are based prove incorrect or shouldunanticipated circumstances arise, our actual results could materially differfrom those anticipated by such forward-looking statements. The differencescould be caused by a number of factors or combination of factors, including,but not limited to, the “Certain factors that may affect our future operatingresults” described herein and the Risk Factors described in our Securities andExchange Commission filings, including the Form 10-K filing for the yearended December 31, 2004.

 

### **Overview**

 

We are a leading provider of softwareapplications for contact centers and plan to leverage that leadership positionto provide mission critical VoIP applications to enterprises. Our customers arein a wide variety of fields including financial institutions, government,healthcare and retail, among others. We are a global software provider with a presencein North America, Europe, Middle East and Africa (EMEA), and the Asia Pacific region(APAC).

 

### **Financial Highlights**

 

For the years ending December 31, 2004and 2003 we saw a growth rate in revenues of 7% and 8%, respectively. Revenuegrowth within any given quarter varies. Factors such as our potential customers’budget constraints, personnel resources to implement the software, andwillingness to implement a critical telecommunications system, can affect thetiming of when our revenues occur.

 

The information below shows our totalrevenues (in millions) for the most recent five quarters and the previous twoyears and percentage change over the previous period.

 
| **Period**                   | ** ** | **Revenues** | ** ** | **% Growth** | ** ** |
|------------------------------|------------|--------------|------------|--------------|------------|
| Three months  ended:         |       |         |       |         |       |
| June 30,  2005          |       | $            | 15.6       |         | 7          | % |
| March 31,  2005         |       | 14.6         |       | 2            |       |
| December 31,  2004      |       | 14.4         |       | 7            |       |
| September 30,  2004     |       | 13.4         |       | (2           | )          |
| June 30,  2004          |       | 13.6         |       | —       |       |
|                         |       |         |       |         |       |
| Year ended December 31: |       |         |       |         |       |
| 2004                         |       | $            | 55.1       |         | 7          | % |
| 2003                         |       | 51.5         |       | 8            |       |

 

Our experience is that once organizationshave implemented our software and their personnel experience the capabilitiesand efficiencies of our software, these organizations tend to increase theirspending for our software. However, we cannot assure you that this willcontinue to be the case. Future licensing to new customers is dependent on theeconomy and whether companies will allocate their resources to upgrade theirsystems.

 

Revenues recognized in the three and sixmonths ended June 30, 2005 increased $2.0 million and $2.9 million,respectively, over revenues for the three and six months ended June 30,2004. Product revenues increased 18% in the three months ended June 30,2005 and services revenues increased 10%. For the six

 

11

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months ended June 30, 2005, product revenues increased 15%, whileservices revenues increased 6%. Prior to 2004 the majority of license revenueswere recognized under annually renewable licenses over the license term,generally one year. In the first quarter of 2004, we began offering perpetuallicenses to our new customers and therefore the recognition of revenues on newcontracts signed was accelerated compared to how revenues were recognized underannually renewable licenses. In the three and six months ended June 30,2005, 69% and 67%, respectively, of the product revenues recognized wererelated to perpetual license agreements compared to 39% and 45% of the productrevenues in the three and six months ended June 30, 2004, respectively.

 

We formed a new subsidiary, Vonexus, on July 1,2004. Vonexus is focused on selling a complete IP-based phone system, includinghardware, to Microsoft-based small and medium-sized businesses. As a result ofthe formation of Vonexus and this new market focus, we have experienced higherexpenses since the third quarter of 2004, mainly in sales and marketing, and incost of product. In the first six months of 2005, we began recognizing revenuesrelated to Vonexus, which to date have not been material to our total revenues.We expect the higher levels of sales and marketing and other costs to continue,however we expect these to be flat with operating costs that were experiencedin the first half of 2005. We expect to record increasing revenues in theremainder of 2005 from Vonexus. We also expect to incur additional costs ofrevenues related to hardware costs for Vonexus and, as a consequence, ifVonexus sales become significant, our gross profits as a percentage of revenuesmay decline.

 

Operating expenses for the three and sixmonths ended June 30, 2005 increased $1.2 million and $2.1 million,respectively, compared to the three and six months ended June 30, 2004.The increase for the three and six months was due to an increase in Vonexussales and marketing and general and administrative expenses, higher payrollexpenses due to increased staffing and an increase in travel expenses partiallyoffset by lower depreciation expenses and lower expense for corporateinsurance.

 

During the second quarter of 2005, wereclassified certain foreign currency transaction gains and losses and foreigntax withholdings, from sales and marketing, and general and administrativeexpenses, for prior periods to other income (expense). The reclassificationshad no impact on our total consolidated results in any period presented.

 

We had $13.6 million of cash and cashequivalents as of June 30, 2005. We had borrowings under a line of creditof $3.0 million as of June 30, 2005, which have since been repaid in full.Cash decreased from $15.2 million as of March 31, 2005 due to lower thanexpected accounts receivable cash collections. As we focus on cash collections in the third quarter, we expect that cashwill increase. We believe that if our revenues increase, our accountsreceivable are collected timely and our expenses remain controlled, we willmaintain or increase our liquidity position.

 

### **Historical Results 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 resultsfor the three and six months ended June 30, 2005 and 2004 are notnecessarily indicative of the results that may be expected for the full year orfor any future period.

 

12

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| ** **                       | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|----------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                       | ** ** | **June 30,**      | ** ** | **June 30,**    | ** ** |
| ** **                       | ** ** | **2005**               | ** ** | **2004**             | ** ** | **2005** | ** ** | **2004** | ** ** |
| Revenues:                        |       |                   |       |                 |       |   |   |   |   |
| Product                          |       | 55                     | %          | 53                   | %          | 55 | % | 52 | % |
| Services                         |       | 45                     |       | 47                   |       | 45 |   | 48 |   |
| Total  revenues                  |       | 100                    |       | 100                  |       | 100 |   | 100 |   |
| Cost of  revenues:               |       |                   |       |                 |       |   |   |   |   |
| Product                          |       | 7                      |       | 3                    |       | 6 |   | 3 |   |
| Services                         |       | 17                     |       | 20                   |       | 18 |   | 21 |   |
| Total cost  of revenues          |       | 24                     |       | 23                   |       | 24 |   | 24 |   |
| Gross profit                     |       | 76                     |       | 77                   |       | 76 |   | 76 |   |
| Operating  expenses:             |       |                   |       |                 |       |   |   |   |   |
| Sales and  marketing             |       | 39                     |       | 37                   |       | 40 |   | 37 |   |
| Research and  development        |       | 21                     |       | 24                   |       | 21 |   | 24 |   |
| General and  administrative      |       | 13                     |       | 13                   |       | 13 |   | 13 |   |
| Restructuring  and other charges |       | —                 |       | 1                    |       | — |   | — |   |
| Total  operating expenses        |       | 73                     |       | 75                   |       | 74 |   | 74 |   |
| Operating  income                |       | 3                      |       | 2                    |       | 2 |   | 2 |   |
| Other income  (expense):         |       |                   |       |                 |       |   |   |   |   |
| Interest  income, net            |       | —                 |       | —               |       | — |   | — |   |
| Other income  (expense)          |       | (1                     | )          | —               |       | (1 | ) | — |   |
| Total other  income (expense)    |       | (1                     | )          | —               |       | (1 | ) | — |   |
| Income  before income taxes      |       | 2                      |       | 2                    |       | 1 |   | 2 |   |
| Income taxes                     |       | —                 |       | —               |       | — |   | — |   |
| Net income                       |       | 2                      | %          | 2                    | %          | 1 | % | 2 | % |

 

**Comparison of Three and Six Months Ended June 30,2005 and 2004**

 

##### ***Revenues***

 

## *Product Revenues*

 
| ** **                    | ** ** | **Three Months Ended**    | ** ** | **Six Months Ended** | ** ** |
|-------------------------------|------------|---------------------------|------------|----------------------|------------|
| ** **                    | ** ** | **June 30,**         | ** ** | **June 30,**    | ** ** |
| ** **                    | ** ** | **2005**                  | ** ** | **2004**             | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                    | ** ** | **($ in thousands)** | ** ** |
| Product  revenues             |       | $                         | 8,596      |                 | $          | 7,261 |   | $ | 16,482 |   | $ | 14,356 |   |
| Change from  prior year       |       | 18                        | %          | 26                   | %          | 15 | % | 0 | % |
| Percentage  of total revenues |       | 55                        | %          | 53                   | %          | 55 | % | 52 | % |
|                               |            |                           |            |                      |            |  |  |  |  |  |  |  |  |

 

The increase in product revenues was relatedprimarily to an increase in the percentage of perpetual license agreements werecognized in 2005, an increase in the number of license agreements we signedand Vonexus revenues, which we began recognizing in 2005. Prior to 2004 themajority of license revenues were recognized under annually renewable licensesover the license term, generally one year. In the first quarter of 2004, webegan offering perpetual licenses to our new customers and therefore therecognition of revenues on new contracts signed was accelerated compared to howrevenues were recognized under annually renewable licenses. In the three andsix months ended June 30, 2005, 71% and 69%, respectively, of the productrevenues recognized were related to perpetual license agreements compared to44% and 42% of the product revenues in the three and six months ended June 30,2004, respectively.

 

Sales pursuant to license agreementsincreased 56% in the three months ended June 30, 2005, compared to the threemonths ended June 30, 2004, and increased 35% for the six months ended June 30,2005 compared to the six months ended June 30, 2004.

 

The percent of product revenues to totalrevenues increased slightly due to the higher rate of increase in productrevenues as compared to services revenues.

 

13

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## *Services Revenues*

 
| ** **                    | ** ** | **Three Months Ended**    | ** ** | **Six Months Ended** | ** ** |
|-------------------------------|------------|---------------------------|------------|----------------------|------------|
| ** **                    | ** ** | **June 30,**         | ** ** | **June 30,**    | ** ** |
| ** **                    | ** ** | **2005**                  | ** ** | **2004**             | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                    | ** ** | **($ in thousands)** | ** ** |
| Services  revenues            |       | $                         | 7,026      |                 | $          | 6,380 |   | $ | 13,733 |   | $ | 12,991 |   |
| Change from  prior year       |       | 10                        | %          | 1                    | %          | 6 | % | 7 | % |
| Percentage  of total revenues |       | 45                        | %          | 47                   | %          | 45 | % | 48 | % |
|                               |            |                           |            |                      |            |  |  |  |  |  |  |  |  |

 

Our services revenues should grow as we signand install new customers and as existing customers continue to renew licensesand pay for maintenance on our software applications. For the three monthsended June 30, 2005, maintenance revenues increased almost $1.3 millionover the three months ended June 30, 2004, however, other servicesrevenues declined $650,000 during the three months ended June 30, 2005compared to the three months ended June 30, 2004 due to lower educationrevenues and a decrease in revenues from consulting activities.

 

Services revenues increased $782,000 for thesix months ended June 30, 2005 compared to the six months ended June 30,2004 due to maintenance revenues increasing by almost $2 million, offset byother services revenues decreasing by $1.2 million for the six months ended June 30,2005 compared to the six months ended June 30, 2004.

 

The percent of services revenues to totalrevenues decreased slightly due to the larger increase in product revenues.

 

##### ***Cost ofRevenues***

 
| ** **                                  | ** ** | **Three Months Ended**    | ** ** | **Six Months Ended** | ** ** |
|---------------------------------------------|------------|---------------------------|------------|----------------------|------------|
| ** **                                  | ** ** | **June 30,**         | ** ** | **June 30,**    | ** ** |
| ** **                                  | ** ** | **2005**                  | ** ** | **2004**             | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                  | ** ** | **($ in thousands)** | ** ** |
| Cost of  revenues:                          |       |                      |       |                 |       |   |   |   |   |
| Product                                     |       | $                         | 1,108      |                 | $          | 404 |   | $ | 1,874 |   | $ | 999 |   |
| Services                                    |       | 2,703                     |       | 2,771                |       | 5,410 |   | 5,524 |   |
| Total cost  of revenues                     |       | $                         | 3,811      |                 | $          | 3,175 |   | $ | 7,284 |   | $ | 6,523 |   |
| Change from  prior year                     |       | 20                        | %          | (11                  | )%         | 12 | % | (8 | )% |
| Product  costs as a % of product revenues   |       | 13                        | %          | 6                    | %          | 11 | % | 6 | % |
| Services  costs as a % of services revenues |       | 38                        | %          | 43                   | %          | 39 | % | 43 | % |

 

Costs of product consist primarily of productand software royalties paid to third parties for the use of their technologiesin our products, hardware costs related to Vonexus and, to a lesser extent,software packaging costs, which include product media, duplication anddocumentation. Costs of product can fluctuate depending on which softwareapplications are licensed to our customers, the third party technology, if any,which is licensed and the number of Vonexus systems sold. The increase in theproduct costs for the three and six months ended June 30, 2005 compared tothe three and six months ended June 30, 2004 was due to Vonexus hardwareand an increase in royalties paid to third party software providers.

 

Costs of services consist primarily ofcompensation expenses for technical support, education and professionalservices personnel, hardware costs related to Interactive Intelligence andother costs associated with supporting our resellers and customers. These costsremained relatively constant for the three and six months ended June 30,2005 compared to the three and six months ended June 30, 2004.

 

14

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

 
| ** **                    | ** ** | **Three Months Ended**    | ** ** | **Six Months Ended** | ** ** |
|-------------------------------|------------|---------------------------|------------|----------------------|------------|
| ** **                    | ** ** | **June 30,**         | ** ** | **June 30,**    | ** ** |
| ** **                    | ** ** | **2005**                  | ** ** | **2004**             | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                    | ** ** | **($ in thousands)** | ** ** |
| Gross profit                  |       | $                         | 11,811     |                 | $          | 10,466 |   | $ | 22,931 |   | $ | 20,824 |   |
| Change from  prior year       |       | 13                        | %          | 23                   | %          | 10 | % | 7 | % |
| Percentage  of total revenues |       | 76                        | %          | 77                   | %          | 76 | % | 76 | % |
|                               |            |                           |            |                      |            |  |  |  |  |  |  |  |  |

 

The increase in gross profit was mainly theresult of an increase in product and services revenues offset by a smallerincrease in cost of revenues as discussed above.

 

##### ***OperatingExpenses***

 

## *Sales and Marketing*

 
| ** **                      | ** ** | **Three Months Ended**    | ** ** | **Six Months Ended** | ** ** |
|---------------------------------|------------|---------------------------|------------|----------------------|------------|
| ** **                      | ** ** | **June 30,**         | ** ** | **June 30,**    | ** ** |
| ** **                      | ** ** | **2005**                  | ** ** | **2004**             | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                      | ** ** | **($ in thousands)** | ** ** |
| Sales and  marketing expenses   |       | $                         | 6,146      |                 | $          | 5,047 |   | $ | 12,000 |   | $ | 10,064 |   |
| Change from  prior year         |       | 22                        | %          | 3                    | %          | 19 | % | (1 | )% |
| Percentage  of total revenues   |       | 39                        | %          | 37                   | %          | 40 | % | 37 | % |
| Percentage  of product revenues |       | 71                        | %          | 70                   | %          | 73 | % | 71 | % |
|                                 |            |                           |            |                      |            |  |  |  |  |  |  |  |  |

 

Sales and marketing expenses are comprisedprimarily of compensation expense, travel, marketing, entertainment and otherrelated expenses. As anticipated and discussed in our Form 10-K for theyear ended December 31, 2004 and in our Form 10-Q for the quarterended March 31, 2005, these expenses increased primarily due to payrollexpenses and other costs associated with Vonexus, our wholly-owned subsidiary.In addition, sales and marketing salaries increased due to our planned focus onmarketing in 2005, and travel expenses also increased.

 

As described previously under FinancialHighlights, we expect these Vonexus costs to continue, and we expect to recordincreased revenues from Vonexus in the third quarter and that Vonexus operatingexpenses will remain fairly constant.

 

## *Research and Development*

 
| ** **                         | ** ** | **Three Months Ended**    | ** ** | **Six Months Ended** | ** ** |
|------------------------------------|------------|---------------------------|------------|----------------------|------------|
| ** **                         | ** ** | **June 30,**         | ** ** | **June 30,**    | ** ** |
| ** **                         | ** ** | **2005**                  | ** ** | **2004**             | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                         | ** ** | **($ in thousands)** | ** ** |
| Research and  development expenses |       | $                         | 3,212      |                 | $          | 3,258 |   | $ | 6,407 |   | $ | 6,536 |   |
| Change from  prior year            |       | (1                        | )%         | (6                   | )%         | (2 | )% | (6 | )% |
| Percentage  of total revenues      |       | 21                        | %          | 24                   | %          | 21 | % | 24 | % |
|                                    |            |                           |            |                      |            |  |  |  |  |  |  |  |  |

 

Research and development expenses arecomprised primarily of compensation expenses. Research and development expenses decreased slightly for the three andsix months ended June 30, 2005 compared to the three and six months ended June 30,2004 due to lower depreciation expense as certain of our assets become fullydepreciated.

 

15

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## *General and Administrative*

 
| ** **                           | ** ** | **Three Months Ended**    | ** ** | **Six Months Ended** | ** ** |
|--------------------------------------|------------|---------------------------|------------|----------------------|------------|
| ** **                           | ** ** | **June 30,**         | ** ** | **June 30,**    | ** ** |
| ** **                           | ** ** | **2005**                  | ** ** | **2004**             | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                           | ** ** | **($ in thousands)** | ** ** |
| General and  administrative expenses |       | $                         | 2,035      |                 | $          | 1,776 |   | $ | 4,056 |   | $ | 3,705 |   |
| Change from  prior year              |       | 15                        | %          | 27                   | %          | 9 | % | 28 | % |
| Percentage  of total revenues        |       | 13                        | %          | 13                   | %          | 13 | % | 13 | % |
|                                      |            |                           |            |                      |            |  |  |  |  |  |  |  |  |

 

General and administrative expenses are primarilycomprised of compensation expense and non-allocable expenses including baddebt, legal and other professional fees. The increase for the three months ended June 30, 2005 compared to thethree months ended June 30, 2004 was due to an increase in professionalservices relating to increased legal fees. The increase for the six months endedJune 30, 2005 compared to the six months ended June 30, 2004 was theresult of higher payroll expenses due to increased staffing and an increase inother office expenses offset partially by lower depreciation expenses and lowerexpense for corporate insurance.

 

##### ***Other Income(Expense)***

 

*Interest Income, net*

 

The majority of interest income, net is madeup of interest earned from investments and interest-bearing cash accounts.Interest expense, which is not material for any periods reported, is alsoincluded in interest income, net. Interest earnings improved during the threeand six months ended June 30, 2005 compared to the three and six monthsended June 30, 2004 as shown below.

 
| ** **                                                   | ** ** | **Three Months Ended**    | ** ** | **Six Months Ended** | ** ** |
|--------------------------------------------------------------|------------|---------------------------|------------|----------------------|------------|
| ** **                                                   | ** ** | **June 30,**         | ** ** | **June 30,**    | ** ** |
| ** **                                                   | ** ** | **2005**                  | ** ** | **2004**             | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                   | ** ** | **($ in thousands)** | ** ** |
| Cash, cash  equivalents and short-term investments (average) |       | $                         | 14,397     |                 | $          | 15,065 |   | $ | 14,121 |   | $ | 15,238 |   |
| Interest  income                                             |       | 69                        |       | 26                   |       | 121 |   | 46 |   |
| Return on  investment                                        |       | 1.9                       | %          | 0.7                  | %          | 1.7 | % | 0.6 | % |
|                                                              |            |                           |            |                      |            |  |  |  |  |  |  |  |  |

 

The increase in net interest income for thethree and six months ended June 30, 2005 compared to the three and sixmonths ended June 30, 2004 was related mainly to a change in the fundsthat we invested in. The new funds have a higher interest rate and lower fees.

 

*Other Income (Expense)*

 

Beginning withthe three months ended June 30, 2005, we are classifying our foreigncurrency transaction gains and losses, as well as foreign tax withholdings inother income (expense) instead of sales and marketing and general andadministrative expenses.  All priorperiods have been reclassified to this presentation. These amounts depend onthe amount of revenue that is generated in certain international currencies,principally the Euro, and the exchange gain or loss that results from foreigncurrency disbursements and receipts.

 
| ** **              | ** ** | **Three Months Ended**    | ** ** | **Six Months Ended** | ** ** |
|-------------------------|------------|---------------------------|------------|----------------------|------------|
| ** **              | ** ** | **June 30,**         | ** ** | **June 30,**    | ** ** |
| ** **              | ** ** | **2005**                  | ** ** | **2004**             | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **              | ** ** | **($ in thousands)** | ** ** | ** **           |
| Other income  (expense) |       | $                         | (136       | )                    | $          | 25 |   | $ | (182 | ) | $ | 72 |   |
|                         |            |                           |            |                      |            |  |  |  |  |  |  |  |  |

 

16

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### **Liquidity and Capital Resources**

 

In 1999 we raised cash through an initialpublic offering that provided net proceeds of $34.9 million. In 2001 wereceived an equity investment that yielded $15.0 million in cash. In addition,we generate cash from the collections we receive related to licensing ourapplication software and from annual license renewals, maintenance and supportand other services revenues. We also have in place a $3.0 million line ofcredit, which we fully utilized as of June 30, 2005, all of which wasrepaid in full subsequent to June 30, 2005. We use cash primarily forpaying our employees (including salaries, commissions, benefits and severance),leasing office space, reimbursing travel expenses, paying insurance premiumsand paying vendors for services rendered and supplies purchased.

 

We determine liquidity by combining cash andcash equivalents and short-term investments net of our line of credit borrowingsas shown in the table below. Our total liquidity position deteriorated as of June 30,2005 compared with our position as of December 31, 2004 due mainly tolower than expected accounts receivable cash collections. We did not have anyshort-term investments at June 30, 2005 or December 31, 2004. Webelieve that our current liquidity position, when combined with our anticipatedcash flows from operations, will be sufficient to satisfy our operating cashneeds over the next 12 months. If cash flows from operations are less thananticipated or we have additional cash needs (such as an unfavorable outcome inlegal proceedings), our liquidity may not be sufficient to cover our needs. Inthis case, we may be forced to raise additional capital, either through thecapital markets or debt financings. We may not be able to receive favorableterms in raising this capital.

 
| ** **                 | ** ** | **June 30,**         | ** ** | **December 31,** | ** ** |
|----------------------------|------------|---------------------------|------------|-----------------------|------------|
| ** **                 | ** ** | **2005**                  | ** ** | **2004**              | ** ** |
| ** **                 | ** ** | **($ in thousands)** | ** ** |
| Cash and  cash equivalents |       | $                         | 13,639     |                  | $          | 14,603 |   |
| Line of  credit            |       | (3,000                    | )          | (3,000                | )          |
| Liquidity,  net            |       | $                         | 10,639     |                  | $          | 11,603 |   |

 

Our operating activities resulted in net cash used of $63,000 and$382,000 for the six months ended June 30, 2005 and 2004, respectively.This decrease in net cash used was primarily a result of lower depreciation andhigher accounts receivable, partially offset by an increase in deferredrevenues.

 

The amount that we report as cash and cashequivalents or as temporary investments fluctuates depending on investingpractices in each period. Purchases of short-term investments are reported as ause of cash and the related receipt of proceeds upon maturity of the investmentis reported as a source of cash.

 

We purchased property and equipment with acost of $1.2 million and $583,000 in the six months ended June 30, 2005 and2004, respectively. These purchases related mainly to in-house technology and leaseholdimprovements for our corporate headquarters.

 

There have been no material changes in ourcontractual obligations described in our Form 10-K for the year ended December31, 2004, except that we are a party to a patent license agreement pursuant towhich we are obligated to pay $250,000 in each of the last two quarters of2005.  Beginning in 2006, the royaltiespayable by us pursuant to this agreement will be based upon our gross revenues,specifically 2% of gross revenues for each of the years 2006 through 2015, and1.5% of gross revenues for each of the years 2016 through 2020.

 

### **Critical Accounting Policies and Estimates**

 

We believe there are three accountingpolicies that are important to understanding our historical and futureperformance, as these policies affect the reported amounts of revenues and arethe more significant areas involving management’s judgments and estimates.These critical accounting policies and estimates relate to revenue recognition,the allowance for doubtful accounts receivable and research and development.These policies, and our procedures related to these policies, are describedbelow.

 

##### ***Sources ofRevenues and Revenue Recognition Policy***

 

We generate product revenues from licensingthe right to use our software applications and generate services revenuesprimarily from annual renewal fees, annual maintenance fees, educationalservices and professional services. We believe both of these sources ofrevenues are critical to our financial statements

 

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because of their materiality to our statements as a whole and becauseof the judgment required in determining if revenue recognition criteria have beenmet.

 

## *Product Revenues*

 

Our software license agreements are eitherannually renewable or perpetual. For any revenues to be recognized from asoftware license agreement, the following criteria must be met:

 

•      persuasiveevidence of an arrangement exists;

•      the fee isfixed or determinable;

•      collection isprobable; and

•      delivery hasoccurred.

 

For an annually renewable software licenseagreement, upon meeting the revenue recognition criteria above, we recognize amajority of the initial license fees under these agreements as product revenuesratably over the initial license period, which is generally 12 months, and theremainder of the initial license fees are recognized as services revenues overthe same time period.

 

For a perpetual software license agreement,upon meeting the revenue recognition criteria above, we immediately recognizeas product revenues the amount of initial license fees if sufficient vendorspecific objective evidence exists to support allocating a portion of the totalfee to the undelivered elements of the arrangement. If sufficient vendorspecific objective evidence of the fair value of the undelivered elements doesnot exist, we recognize the initial license fee as product revenues ratablyover the initial term of the maintenance agreement, which is generally 12months but at times may be more than 12 months because maintenance begins whenthe licenses are downloaded which is typically within six months of thecontract date.

 

## *Services Revenues*

 

Services revenues are recognized for annuallyrenewable software license agreements and perpetual software licenseagreements. In the initial year of the contract, the allocation of the initialorder between product revenues and services revenues is based on the actualrenewal fee for perpetual licenses and based on an estimated percentage forannually renewable software license agreements. After the initial licenseperiod, our customers may renew their license agreement for an additionalperiod, typically 12 months, by paying a renewal fee.  We recognize annual maintenance fees asservices revenues ratably over the post-contract maintenance period, which istypically 12 months.

 

We also generate revenues from other servicesthat we provide to our resellers and customers. These additional revenuesinclude fees for educational services and professional services. Revenues fromeducational services, which consist of training courses for resellers andcustomers, and professional services, which include implementing our productsfor a customer, are recognized as the related services are performed.

 

##### ***Allowance forDoubtful Accounts Receivable***

 

We adjust our allowance for doubtful accountsfor each reporting period based on an average bad debt expense to revenue ratioand based on a detailed analysis of our accounts receivable at the end of thatperiod. In estimating the allowance for doubtful accounts, we primarilyconsider the age of the reseller’s or customer’s receivable and also considerthe creditworthiness of the reseller or customer, the economic conditions ofthe customer’s industry, and general economic conditions, among other factors.If payment is not made timely, we contact the customer or reseller to try toobtain payment. If this is not successful, we institute other collectionpractices such as generating collection letters, involving our salesrepresentatives and ultimately terminating the customer’s or reseller’s accessto future upgrades, licenses and customer support. Once all collection effortsare exhausted, the receivable is written off against the allowance for doubtfulaccounts.

 

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##### ***Research andDevelopment***

 

Through June 30, 2005,all research and development expenditures have been expensed as incurred. Basedon our product development process and technological feasibility, the date atwhich capitalization of development costs may begin is established uponcompletion of a working model. Costs incurred between completion of the workingmodel and the point at which the product is ready for general release have beeninsignificant.

 

**Certain factors that may affect our futureoperating results are set forth below:**

 

**THE OVERALL ECONOMIC CLIMATE MAY BE WEAK**

 

Our products typically represent substantialcapital commitments by customers and involve a potentially long sales cycle. Asa result, customer purchase decisions may be significantly affected by avariety of factors, including general economic trends in the allocation ofcapital spending budgets to communication software, services and systems,lengthened sales cycles, customer approval processes, and market conditions,which have resulted in many of our customers delaying and/or reducing theircapital spending related to information systems. If the economy weakens, demandfor our products could decrease, resulting in lower revenues.

 

**WE HAVE HISTORICALLY INCURRED LOSSES AND WE MAY NOTSUSTAIN PROFITABILITY**

 

At June 30, 2005, we had accumulated netlosses since inception of $60.0 million. We incurred net losses of $5.9million and $7.7 million in 2003 and 2002, respectively. Since the firstquarter of 2004, we have reported net income, however we may not do so again inthe future. We intend to continue to make significant investments in ourresearch and development, marketing, services, sales operations and our newsubsidiary, Vonexus. In addition, as discussed in Note 6 of Notes toConsolidated Financial Statements, FASB Statement No. 123R will have anadverse effect on our operating results when we implement it. As a result, wemay experience losses in future quarters.

 

**OUR QUARTERLY OPERATING RESULTS HAVE VARIEDSIGNIFICANTLY**

 

Our operating results have variedsignificantly from quarter to quarter and may continue to do so in the futuredepending on a number of factors affecting us or our industry, including manythat are beyond our control. As a result, we believe that period-to-periodcomparisons of our operating results are not necessarily meaningful, and youshould not rely on them as an indication of our future performance. Inaddition, our operating results in a future quarter or quarters may fall belowexpectations of securities analysts or investors and, as a result, the price ofour common stock may fluctuate.

 

Because we do not know if or when ourpotential customers will place orders and finalize licenses, and because it isdifficult to predict the mix of annually renewable licenses and perpetuallicenses in a quarter, we cannot accurately forecast our licensing activity,our revenues and our operating results for future quarters. We recognizerevenues from different licenses over different periods depending on thesatisfaction of the requirements of relevant accounting literature, includingAICPA Statement of Position 97-2, Statement of Position 98-9, SEC StaffAccounting Bulletin (SAB) 104, and all related AICPA Technical Practice Aids(5100.38 - 5100.76). As a result, our quarterly revenues andoperating results depend on many factors, including the type of license, thesize, quantity and timing of orders received for our products during eachquarter, the delivery of the related software and our expectations regardingcollection. If a large number of orders or several large orders do not occur orare deferred or delayed, our revenues in a quarter could be substantiallyreduced. This risk is heightened by the significant investment and executivelevel decision-making typically involved in our customers’ decisions to licenseour products. Since a large portion of our operating expenses, includingsalaries and rent, is fixed and difficult to reduce

 

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or modify in a short time period, our business, financial condition orresults of operations could be materially adversely affected if revenues do notmeet our expectations.

 

Our limited number of products, changes inpricing policies, the timing of development completion, and announcement andsale of new or upgraded versions of our products are some of the additionalfactors that could cause our revenues and operating results to vary significantlyfrom quarter to quarter.

 

**WE HAVE A LENGTHY PRODUCT SALES CYCLE WHICHHAS CONTRIBUTED AND MAY CONTINUE TO CONTRIBUTE TO THE VARIABILITY OFQUARTERLY OPERATING RESULTS**

 

We have generally experienced a lengthyproduct sales cycle, averaging approximately six to nine months. The lengthysales cycle is one of the factors that has caused, and may in the futurecontinue to cause, our product revenues and operating results to varysignificantly from quarter to quarter, which could affect the market price of ourcommon stock. The lengthy sales cycle also makes it difficult for us toforecast product license revenues. Because of the unique characteristics of ourproducts, our prospective customers’ decisions to license our products oftenrequire significant investment and executive-level decision making. We believethat many companies currently are not aware of the benefits of interactionmanagement software of the type that we license or of our products andcapabilities. For this reason, we must provide a significant level of educationto prospective customers about the use and benefits of our products, which cancause potential customers to take many months to make these decisions. As aresult, sales cycles for customer orders vary substantially from customer to customer.Excessive delay in product sales could materially adversely affect ourbusiness, financial condition or results of operations.

 

The length of the sales cycle for customerorders depends on a number of other factors over which we have little or nocontrol, including:

 

•      a customer’sbudgetary constraints;

•      the timing of acustomer’s budget cycles;

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

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

 

**OUR INABILITY TO SUCCESSFULLY MANAGE OURINCREASINGLY COMPLEX THIRD PARTY RELATIONSHIPS COULD ADVERSELY AFFECT US**

 

As the complexity of our product technologyand our reseller and other third party relationships have increased, themanagement of those relationships and the negotiation of contractual termssufficient to protect our rights and limit our potential liabilities havebecome more complicated, and we expect this trend to continue in the future. Inaddition, the formation of our wholly-owned subsidiary, Vonexus, which offersthrough resellers a whole product solution, has added complexity to those thirdparty relationships. As a result, our inability to successfully manage theserelationships or negotiate sufficient contractual terms could have a materialadverse effect on us.

 

**WE FACE COMPETITIVE PRESSURES, WHICH MAY HAVEA MATERIAL ADVERSE EFFECT ON US**

 

The market for our software applications ishighly competitive and, because there are relatively low barriers to entry inthe software market, we expect competitive pressures to continue to be a riskto our ongoing success in the market. In addition, because our industry isevolving and characterized by rapid technological change, it is difficult forus to predict whether, when and by whom new competing technologies or newcompetitors may be introduced into our markets. Currently, our competitioncomes from several different market segments, including computer telephonyplatform developers, computer telephony applications software developers andtelecommunications equipment vendors. We cannot

 

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provide assurance that we will be able to compete effectively againstcurrent and future competitors. In addition, increased competition or othercompetitive pressures may result in price reductions, reduced margins or lossof market share, any of which could have a material adverse effect on ourbusiness, financial condition or results of operations.

 

Many of our current and potential competitorshave longer operating histories, significantly greater resources, greater namerecognition and a larger installed base of customers than we do. As a result,these competitors may be able to respond to new or emerging technologies andchanges in customer requirements more effectively than we can, or to devotegreater resources to the development, promotion and sale of products than wecan. In addition, for a number of our larger competitors, the product segmentin which they currently compete with us is a small portion of their overalloffering. These competitors might be willing and able to dramatically cutprices in our segment in order to protect or grow other segments that are moreimportant to their overall business. Current and potential competitors haveestablished, and may in the future establish, cooperative relationships amongthemselves or with third parties, including mergers or acquisitions, toincrease the ability of their products to address the needs of our current orprospective customers. If these competitors were to acquire significantlyincreased market share, it could have a material adverse effect on ourbusiness, financial condition or results of operations.

 

**WE MAY NOT BE ABLE TO GROW OUR BUSINESSIF WE DO NOT MAINTAIN SUCCESSFUL RELATIONSHIPS WITH OUR RESELLERS AND PARTNERSAND CONTINUE TO RECRUIT AND DEVELOP ADDITIONAL SUCCESSFUL RESELLERS ANDPARTNERS**

 

Our ability to achieve revenue growth in thefuture will depend in part on our success in maintaining successfulrelationships with our existing and future resellers and partners and inrecruiting and training additional resellers and partners. We rely primarily onresellers to market and support our products and plan on continuing to relyheavily on such partners in the future. We are still developing our resellerand distribution networks and may be unable to attract additional resellerswith both voice and data expertise or appropriate partners that will be able tomarket our products effectively and that will be qualified to provide timelyand cost-effective customer support and service. We generally do not havelong-term or exclusive agreements with our resellers or partners, and the lossof specific larger resellers or partners or a significant number of resellersor partners could materially adversely affect our business, financial conditionor results of operations.

 

**OUR MARKETS ARE CHARACTERIZED BY RAPIDTECHNOLOGICAL CHANGE WHICH MAY CAUSE US TO INCUR SIGNIFICANT DEVELOPMENTCOSTS AND PREVENT US FROM ATTRACTING NEW CUSTOMERS**

 

The market for our products is characterizedby rapid technological change, frequent new product introductions andenhancements, uncertain product life cycles and changing 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 and prevent us from attractingnew customers.

 

**A DECLINE IN MARKET ACCEPTANCE FOR MICROSOFTTECHNOLOGIES ON WHICH OUR PRODUCTS RELY COULD HAVE A MATERIAL ADVERSE EFFECT ONUS**

 

Our products currently run only on MicrosoftWindows operating systems. In addition, our products use other Microsofttechnologies, 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 to marketour current products. Although we believe that Microsoft technologies willcontinue to be widely used by businesses, we cannot assure you that businesseswill adopt these technologies as anticipated or will not in the future migrateto other competing technologies that we do not

 

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currently support. In addition, our products and technologies mustcontinue to be compatible with new developments in Microsoft technologies.

 

**OUR FUTURE BUSINESS PROSPECTS DEPEND IN PART ONOUR ABILITY TO MAINTAIN AND IMPROVE OUR CURRENT PRODUCTS AND DEVELOP NEWPRODUCTS**

 

We believe that our future business prospectsdepend in large part on our ability to maintain and improve our currentsoftware applications and to develop new software applications on a timelybasis. Our software applications will have to continue to achieve marketacceptance, maintain technological competitiveness and meet an expanding rangeof customer requirements. As a result of the complexities inherent in ourapplications, major new applications and application enhancements require longdevelopment and testing periods. We may not be successful in developing andmarketing, on a timely and cost effective basis, application enhancements ornew software applications that respond to technological change, evolvingindustry standards or customer requirements. We may also experiencedifficulties that could delay or prevent the successful development,introduction or marketing of application enhancements, and our new applicationsand application enhancements may not achieve market acceptance. Significantdelays in the general availability of new releases of our software applicationsor significant problems in the installation or implementation of new releasesof our applications could have a material adverse effect on our business,financial condition or results of operations.

 

**SLOW GROWTH, OR A DECLINE IN DEMAND FORINTERACTION MANAGEMENT SOFTWARE OF THE TYPE WE LICENSE, COULD MATERIALLYADVERSELY AFFECT OUR FINANCIAL RESULTS AND GROWTH PROSPECTS**

 

If the demand for interaction managementsoftware of the type we license does not grow within each of our four targetedmarkets, our financial results and ability to grow our business could bematerially adversely affected. All of our revenues have been generated fromlicenses of our Interaction Center Platform software or complementary products,and related support, educational and professional services. We expect theseproducts and services to account for the majority of our revenues for theforeseeable future. Although we believe demand for the functions performed byour products is high, the market for our products and services is stillemerging. Further, our growth plans require us to successfully attractenterprise and service provider customers in significantly larger numbers thanwe have historically achieved.

 

**IF OUR CUSTOMERS DO NOT PERCEIVE OUR PRODUCTSOR THE RELATED SERVICES PROVIDED BY US OR OUR RESELLERS OR PARTNERS TO BEEFFECTIVE OR OF HIGH QUALITY, OUR BRAND AND NAME RECOGNITION WILL SUFFER**

 

We believe that establishing and maintainingbrand and name recognition is critical for attracting, retaining and expandingcustomers 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 which can beassured. If our customers do not perceive our products or related services tobe effective or of high quality, our brand and name recognition would sufferwhich could have a material adverse effect on our business, financial conditionor results of operations.

 

**WE MAY NOT BE ABLE TO PROTECT OURPROPRIETARY RIGHTS ADEQUATELY, WHICH COULD ALLOW THIRD PARTIES TO COPY OROTHERWISE OBTAIN AND USE OUR TECHNOLOGY WITHOUT AUTHORIZATION**

 

We regard our software products asproprietary. In an effort to protect our proprietary rights, we rely primarilyon a combination of copyright, trademark and trade secret laws, as well aspatents, licensing and

 

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other agreements with consultants, suppliers, strategic and partners,resellers and customers, and employee and third-party non-disclosureagreements. These laws and agreements provide only limited protection of ourproprietary rights. It may be possible for a third party to copy or otherwiseobtain and use our technology without authorization. A third party could alsodevelop similar technology independently. In addition, the laws of somecountries in which we license our products do not protect our software andintellectual property rights to the same extent as the laws of the UnitedStates. Unauthorized copying, use or reverse engineering of our products couldmaterially adversely affect our business, results of operations or financialcondition.

 

We license technology that is embedded in ourproducts. If one or more of these licenses terminates or cannot be renewed onsatisfactory 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.

 

**INFRINGEMENT CLAIMS COULD ADVERSELY AFFECT US**

 

Third parties have claimed or may in thefuture claim that our technology infringes their proprietary rights. As thenumber of software products in our target markets increases and thefunctionality of these products overlap, we believe that software developersmay face additional infringement claims. See Note 5 of Notes to CondensedConsolidated Financial Statements for a description of contingencies.

 

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

 

**WE DEPEND ON KEY PERSONNEL AND WILL NEED TORETAIN AND RECRUIT SKILLED PERSONNEL, FOR WHICH COMPETITION IS INTENSE, TOCONDUCT AND GROW OUR BUSINESS EFFECTIVELY**

 

Our success depends in large part on thecontinued service of our key personnel, particularly Dr. Donald E. Brown,our Chief Executive Officer and principal stockholder. The loss of the servicesof Dr. Donald E. Brown or other key personnel could have a materialadverse effect on our business, financial condition or results of operations.Our future success also depends on our ability to attract, train, assimilateand retain additional qualified personnel. Competition for persons with skillsin the software industry is intense, particularly for those with relevanttechnical and/or sales experience. We cannot assure you that we will be able toretain our key employees or that we can attract, train, assimilate or retainother highly qualified personnel in the future.

 

**WE MAY PURSUE ACQUISITIONS THAT BY THEIRNATURE PRESENT RISKS AND THAT MAY NOT BE SUCCESSFUL**

 

In the future we may pursue 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 ofoperations:

 

•      We cannotassure that any acquired businesses will achieve anticipated revenues, earningsor cash flow.

•      We may beunable to integrate acquired businesses successfully and realize anticipatedeconomic, operational and other benefits in a timely manner, particularly if weacquire a business in a market in which we have limited or no currentexpertise, or with a corporate culture different from our

 

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own. If we areunable to integrate acquired businesses successfully, we could incursubstantial costs and delays or other operational, technical or financialproblems.

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

•      We may financefuture acquisitions by issuing common stock for some or all of the purchaseprice. This could dilute the ownership interests of our stockholders. We mayalso incur additional debt or be required to recognize expense related tointangible assets recorded in future acquisitions.

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

 

**OUR INTERNATIONAL OPERATIONS INVOLVEFINANCIAL AND OPERATIONAL RISKS**

 

Our international operations requiresignificant management attention and financial resources to establish andoperate, including hiring appropriate personnel and recruiting effectiveinternational resellers. Non-North American revenues accounted for 25%, 22% and13% of our total revenues for the six months ended June 30, 2005 and theyears ended December 31, 2004 and 2003, respectively. We have marketingefforts in the Americas, EMEA and APAC. We intend to continue to emphasize ourinternational operations and we may enter additional international markets.Revenues from international operations may be inadequate to cover the expensesof those operations. In addition to foreign currency fluctuation risks, other risksinherent in our international business activities may include the following:

 

•      economic andpolitical instability;

•      unexpectedchanges in foreign regulatory requirements and laws;

•      tariffs andother trade barriers;

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

•      lack ofacceptance of our products in foreign countries;

•      longer salescycles and accounts receivable payment cycles;

•      potentiallyadverse tax consequences;

•      restrictions onthe repatriation of funds;

•      acts ofterrorism; and

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

 

**FLUCTUATIONS IN THE VALUE OF FOREIGNCURRENCIES COULD RESULT IN LOSSES**

 

Our international revenues are generallydenominated in U.S. dollars with the exception of some European resellers andcustomers located in countries that have adopted the Euro as their officialcurrency. Our international expenses are generally denominated in local foreigncurrencies. Although foreign currency transaction gains and losses have notbeen significant to date, fluctuations in exchange rates between the U.S.dollar and other currencies could have a material adverse effect on ourbusiness, financial condition or results of operations, and particularly on ournet income. To date, we have minimally sought to hedge the risks associatedwith fluctuations in exchange rates, but we may more actively undertake to doso in the future. Any hedging techniques we implement in the future may not besuccessful. Exchange rate fluctuations could also make our products moreexpensive than competitive products not subject to these fluctuations, whichcould adversely affect our revenues and profitability in international markets.

 

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**OUR PRODUCTS COULD HAVE DEFECTS FOR WHICH WEARE POTENTIALLY LIABLE AND WHICH COULD RESULT IN LOSS OF REVENUE, INCREASEDCOSTS, LOSS OF OUR CREDIBILITY OR DELAY IN ACCEPTANCE OF OUR PRODUCTS IN THEMARKET**

 

Our products, including components suppliedby others, may contain errors or defects, especially when first introduced orwhen new versions are released. Despite internal product testing, we have inthe past discovered software errors in some of our products after theirintroduction. Errors in new products or releases could be found aftercommencement of commercial shipments, and this could result in additionaldevelopment costs, diversion of technical and other resources from our otherdevelopment efforts, or the loss of credibility with current or futurecustomers. This could result in a loss of revenue or delay in market acceptanceof our products, which could have a material adverse effect on our business,financial condition or results of operations.

 

Our license agreements with our customerstypically contain provisions designed to limit our exposure to potentialproduct liability and some contract claims. However, not all of theseagreements contain these types of provisions and, where present, theseprovisions vary as to their terms and may not be effective under the laws ofsome jurisdictions. A product liability, warranty, or other claim broughtagainst us could have a material adverse effect on our business, financialcondition or results of operations.

 

Our software runs on aWindows 2000 or Windows 2003 server and for telephone call processing usesvoice processing boards or third party VoIP media processing software such asIntel HMP software.  Our server softwarealso operates in a complex network environment with database servers, emailservers and other third party systems. Performance interruptions at ourcustomer sites, most of which currently do not have back-up systems, couldaffect demand for our products or give rise to claims against us.

 

**WE MAY NOT BE ABLE TO OBTAIN ADEQUATEFINANCING TO IMPLEMENT OUR STRATEGY**

 

Successful implementation of our 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.

 

**OUR STOCK PRICE HAS BEEN AND COULD CONTINUETO BE HIGHLY VOLATILE**

 

Our stock price has been and could continueto be highly volatile due to a number of factors, including:

•      actual oranticipated fluctuations in our operating results;

•      announcementsby us, our competitors or our customers;

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

•      technologicalinnovations by others;

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

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

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

•      general marketor economic conditions.

 

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This risk may be heightened because ourindustry is relatively new and evolving, characterized by rapid technologicalchange and susceptible to the introduction of new competing technologies orcompetitors.

 

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.

 

**OUR COMMON STOCK IS SUBJECT TO VARIOUSLISTING REQUIREMENTS**

 

The various markets operated by The NASDAQStock Market have quantitative maintenance criteria for continued listing ofcommon stock. We may be delisted from one or more NASDAQ markets if we fail tocomply with the criteria. While we believe that we currently meet criteria forlisting on a market operated by The NASDAQ Stock Market, we can offer noassurance that our common stock will continue to meet the various criteria forcontinued listing on any market operated by The NASDAQ Stock Market. Anydelisting may result in a reduction in the liquidity of our common stock, whichmay have a material adverse effect on the price of our common stock.

 

**REGULATORY CHANGES MADE TO GENERALLY ACCEPTEDACCOUNTING PRINCIPLES OR CORPORATE GOVERNANCE MATTERS MAY IMPACT OURBUSINESS**

 

Revisions to generally accepted accountingprinciples will require us to review our accounting and financial reportingprocedures in order to ensure continued compliance with required policies. Fromtime to time, such changes may have a short-term impact on our reporting, andthese changes may impact market perception of our financial condition. Inaddition, legislative changes, and the perception these changes create, canhave a material, adverse effect on our business. For example:

 

•      pending or newlegislation, such as the Sarbanes-Oxley 404 regulations, may lead to anincrease in our costs related to audits in particular and regulatory compliancegenerally; and

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

 

**OUR EXECUTIVE OFFICERS AND DIRECTORS CONTROLUS AND MAY MAKE DECISIONS THAT SHAREHOLDERS DO NOT CONSIDER TO BE IN THEIRBEST INTERESTS**

 

Our current directors and executive officerstogether beneficially own more than 50% of our outstanding common stock.Accordingly, these shareholders are able to control us through their ability todetermine the outcome of the election of our directors, amend our RestatedArticles of Incorporation and By-Laws and take other actions requiring the voteor consent of shareholders, including mergers, going private transactions andother extraordinary transactions, and the terms of any of these transactions.The ownership position of these shareholders may have the effect of delaying,deterring or preventing a change in control or a change in the composition ofour board of directors.

 

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**ANTI-TAKEOVER PROVISIONS IN OURORGANIZATIONAL DOCUMENTS AND INDIANA LAW MAKE ANY CHANGE IN CONTROL OF US MOREDIFFICULT, MAY DISCOURAGE BIDS AT A PREMIUM OVER THE MARKET PRICE AND MAY ADVERSELYAFFECT THE MARKET PRICE OF OUR STOCK**

 

Our Restated Articles of Incorporation andBy-Laws contain provisions that may have the effect of delaying, deferring orpreventing a change in control of us, may discourage bids at a premium over themarket price of our common stock and may adversely affect the market price ofour common stock, and the voting and other rights of the holders of our commonstock. These provisions include:

 

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

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

•      prohibitingshareholders from calling a special meeting of shareholders;

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

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

 

The Indiana corporation law contains businesscombination provisions that, in general, prohibit for five years any businesscombination with a beneficial owner of 10% or more of our common stock unlessthe holder’s acquisition of the stock was approved in advance by our board ofdirectors. The Indiana corporation law also contains control share acquisitionprovisions that limit the ability of certain shareholders to vote their sharesunless their control share acquisition was approved in advance.

 

**WE CANNOT PREDICT EVERY EVENT ANDCIRCUMSTANCE THAT MAY IMPACT OUR BUSINESS AND, THEREFORE, THE RISKS ANDUNCERTAINTIES DISCUSSED ABOVE MAY NOT BE THE ONLY ONES YOU SHOULD CONSIDER**

 

The risks and uncertainties discussed aboveare in addition to those that apply to most businesses generally. In addition,as we continue to grow our business, we may encounter other risks of which weare not aware at this time. These additional risks may cause serious damage toour business in the future, the impact of which we cannot estimate at thistime.

 

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

 

We developproducts in the United States and license our products in the Americas, EMEAand APAC. As a result, our financial results could be affected by variousfactors, including changes in foreign currency exchange rates or weak economicconditions in foreign markets. As most sales are currently made in U.S.dollars, a strengthening of the dollar could make our products less competitivein foreign markets. Additionally, as our business matures in foreign markets,we may offer our products and services in certain other local currencies. As aresult, we will be subject to foreign currency fluctuations, which may have anadverse affect on our company.

 

We manage our interest rate risk bymaintaining an investment portfolio with debt instruments of high creditquality and relatively short average maturities. We also manage interest raterisk by maintaining sufficient cash and cash equivalent balances such that weare typically able to hold our investments to maturity. We have a line ofcredit with a variable interest rate based upon the bank’s prime rate on whichwe incur interest expense when the line is utilized.

 

**Item 4. Controls and Procedures.**

 

We maintain a set of disclosure controls andprocedures that are designed to ensure that information required to bedisclosed by us in the reports filed by us under the Securities Exchange Act of1934, as amended (Exchange Act) is recorded, processed, summarized and reportedwithin the time periods

 

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specified in the SEC’s rules and forms. We carried out anevaluation, under the supervision and with the participation of our management,including our President and Chief Executive Officer and our Chief FinancialOfficer and Treasurer, of the effectiveness of the design and operation of ourdisclosure controls and procedures as of June 30, 2005 pursuant to Rule 13a-15(b) ofthe Exchange Act. Based on that evaluation, our President and Chief ExecutiveOfficer and our Chief Financial Officer and Treasurer concluded that ourdisclosure controls and procedures were effective.

 

There have been no changes in our internalcontrol over financial reporting that occurred during the quarter ended June 30,2005 that have materially affected, or are reasonably likely to materiallyaffect, our internal control over financial reporting.

 

**PART **II. OTHER INFORMATION

 

**Item 1. Legal Proceedings.**

 

From time to time we have received claims fromcompetitors and other technology providers claiming that our technologyinfringes their proprietary rights. One such claim has resulted in a legalproceeding being filed against us, which is described below. We cannot assureyou that these matters can be resolved amicably without litigation, or that wewill be able to enter into licensing arrangements on terms and conditions thatwould not have a material adverse effect on our business, financial conditionor results of operations.

 

On September 30, 2003, Recursion Software, Inc.filed suit in Dallas County Court in Dallas, Texas against us alleging breachof contract and money due under claims of quantum meruit, unjust enrichment andinfringement. Recursion claims that we incorporated Recursion software into oneof our products in breach of the underlying license. On November 6, 2003,we had the case removed to Federal District Court in Dallas, Texas and on January 28,2004, Recursion asserted a copyright infringement claim against us, which wasexpanded in scope on September 10, 2004. No dollar amount has been statedin the action. We believe that we have strong defenses to the claims and intendto vigorously defend against the action. We believe that this matter can beresolved without a material adverse effect on our business, financial conditionor results of operations; however, we cannot provide assurance as to theoutcome.

 

In November 2002, we received a notification fromthe French government as a result of a tax audit that had been conductedencompassing the years 1998, 1999, 2000 and 2001. These assessments claimvarious taxes are owed related to Value Added Tax (VAT) and corporation taxesin addition to what has previously been paid and accrued. As of June 30,2005, the assessment related to VAT was approximately $2.8 million and theassessment related to corporation taxes was approximately $364,000. Our taxcounsel has assessed the possibility of us paying the assessment related to VATas remote and the assessment related to corporation taxes as reasonably possible.We have not accrued for these amounts. We are appealing the assessments, butcannot assure you that these matters will be resolved without litigation orthat we will not have to pay some or all of the assessments.

 

From time to time, we are also involved in certainintellectual property claims and legal proceedings in the ordinary course ofconducting our business. While the ultimate liability pursuant to these actionscannot currently be determined, we believe these claims and legal proceedingswill not have a material adverse effect on our business, financial condition orresults from operations. Litigation in general, and intellectual propertylitigation in particular, can be expensive and disruptive to normal businessoperations. Moreover, the results of complex legal proceedings are difficult topredict.

 

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**Item 4. Submission of Matters to a Vote ofSecurity Holders.**

 

We held our annual meeting of shareholders on May 19,2005.  At that meeting, our shareholdersreelected Donald E. Brown, M.D. as a Director of the Company to serve athree-year term and until his successor is elected and has qualified. Also atthe meeting, our shareholders approved an amendment to our Employee StockPurchase Plan. The final results of the votes taken at the meeting were asfollows:

 
| ** **             | ** ** | **Votes**  | ** ** | **Votes**    | ** ** | ** ** | ** ** | ** ** | ** ** |
|------------------------|------------|------------|------------|--------------|------------|------------|------------|------------|------------|
| ** **             | ** ** | **For**    | ** ** | **Withheld** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Election of  Director: |       |       |       |         |       |       |       |       |       |
| Donald E.  Brown, M.D. |       | 15,269,149 |       | 106,904      |       |       |       |       |       |

 
|                                       |   | **Votes**  | ** ** | **Votes**    | ** ** | **Broker**    | ** ** | ** **      | ** ** |
|--------------------------------------------|--------|------------|------------|--------------|------------|---------------|------------|-----------------|------------|
|                                       |   | **For**    | ** ** | **Withheld** | ** ** | **Non-Votes** | ** ** | **Abstentions** | ** ** |
| Amendment to  Employee Stock Purchase Plan |   | 11,697,791 |       | 175,178      |       | 3,488,929     |       | 14,155          |       |

 

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

 
| Edward L.  Hamburg, Ph.D.                                      |   | 2006 |   |
|----------------------------------------------------------------|--------|------|--------|
| Samuel F.  Hulbert, Ph.D.                                      |   | 2006 |   |
| William E.  McWhirter                                          |   | 2007 |   |
| Mark E. Hill                                                   |   | 2007 |   |
| Richard A.  Reck (appointed by the Board on July 1, 2005) |   | 2008 |   |

 

**Item 6. Exhibits.**

 

(a)   Exhibits

 

3.1       Restated Articles of Incorporation of theCompany (incorporated herein by reference from the same exhibit number to theCompany’s Registration Statement on Form S-1 (Registration No. 333-79509))

 

3.2           By-Lawsof the Company, as amended to date (incorporated herein by reference from thesame exhibit number to the Company’s Registration Statement on Form S-1(Registration No. 333-79509))

 

10.28       InteractiveIntelligence, Inc. Employee Stock Purchase Plan, as amended (incorporatedherein by reference from the same exhibit number to the Registrant’s CurrentReport on Form 8-K filed on May 24, 2005)

 

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

 

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

 

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

 

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32.2     Certificationof Stephen R. Head, CFO, pursuant to 18 U. S. C. Section 1350, as adoptedpursuant to Section 906 of the Sarbanes-Oxley Act of 2002

 

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**SIGNATURES**

 

Pursuant tothe requirements of the Securities Exchange Act of 1934, the Registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly authorized.

 
|                       |   | Interactive  Intelligence, Inc.                                                               |
|----------------------------|--------|----------------------------------------------------------------------------------------------------|
|                       |   | (Registrant)                                                                                       |
|                       |   |                                                                                               |
| Date: August 15, 2005 | By     | /s/ Stephen  R. Head                                                                               |
|                       |   | Stephen R.  Head                                                                                   |
|                       |   | *Chief  Financial Officer, Vice President of Finance and  Administration, Secretary and Treasurer* |
|                       |   | *(Principal  Financial Officer and Principal Accounting  Officer)*                                 |

 

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