**UNITED
        STATES**
 **SECURITIES
        AND EXCHANGE COMMISSION**
 
 **Washington,
        D.C. 20549**
 
 **____________**
 
 **FORM
        10-Q**
 **(Mark
        One)**
 
 **T**
              **QUARTERLY
                  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
                  ACT OF
                  1934**
 
 **For
        the quarterly period ended September 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____________**
 
 **Commission
        File Number 000-27385**
 
 **INTERACTIVE
        INTELLIGENCE, INC.**
 **(Exact
        name of registrant as specified in its charter)**
 
 **Indiana**
              **35-1933097****(State
                  or other jurisdiction of**
              **(IRS
                  Employer Identification No.)****incorporation
                  or organization)**
 
 **7601
        Interactive Way**
 **Indianapolis,
        Indiana 46278**
 **(Address
        of principal executive offices)**
 
 **(317)
        872-3000**
 **(Registrant's
        telephone number)**
 
 Indicate
        by checkmark whether the registrant (1) has filed all reports required to
        be
        filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
        the
        preceding 12 months (or for such shorter period that the registrant was required
        to file such reports), and (2) has been subject to such filing requirements
        for
        the past 90 days.  Yes  *****  No  **T**
 
 Indicate
        by check mark whether the registrant is an accelerated filer (as defined
        in Rule
        12b-2 of the Exchange Act).  Yes  *****  No  **T**
 
 Indicate
        by check mark whether the registrant is a shell company (as defined in Rule
        12b-2 of the Exchange Act).  Yes  *****  No  **T**
 
 The
        number of shares of common stock outstanding on October 31, 2005 was 16,095,293.
  Table
            of Contents
  TABLE
        OF CONTENTS
 
 
 PART
        I.
        FINANCIAL INFORMATION
 
 Item
                  1.
              Condensed
                  Consolidated Balance Sheets as of September 30, 2005
                  and December 31, 2004
              3Condensed
                  Consolidated Statements of Operations for the three
                  and nine months ended September 30, 2005 and 2004
              4Condensed
                  Consolidated Statement of Shareholders’ Equity for
                  the nine months ended September 30, 2005
              5Condensed
                  Consolidated Statements of Cash Flows for the nine
                  months ended September 30, 2005 and 2004
              6Notes
                  to Condensed Consolidated Financial
                  Statements
              7Item
                  2.
              Management's
                  Discussion and Analysis of Financial Condition
                  and Results of Operations
              10Item
                  3.
              Quantitative
                  and Qualitative Disclosures About Market
                  Risk
              24Item
                  4.
              Controls
                  and Procedures
              24PART
                  II. OTHER INFORMATIONItem
                  1.
              Legal
                  Proceedings
              24Item
                  6.
              Exhibits
              25SIGNATURES
  -2-
 Table
            of Contents
  **PART
        I. FINANCIAL INFORMATION**
 
 **Item
                  1.**
              **Condensed Consolidated Financial Statements and
                  Footnotes.**
 
 **Interactive
        Intelligence, Inc.**
 **Condensed
        Consolidated Balance Sheets**
 **As
        of September 30, 2005 and December 31, 2004**
 **(in
        thousands, except share amounts)**
 
 **September
                  30,**
                **2005**
              
              **December
                  31,**
                **2004****(unaudited)**
              
              **(Note
                  1)****Assets**Current
                  assets:Cash
                  and cash equivalents
              
              $
              13,692
              
              $
              14,603Accounts
                  receivable, net of allowance for doubtful accounts of $582 in 2005
                  and
                  $410 in 2004
              
              
              14,847
              
              
              10,251Prepaid
                  expenses
              
              
              2,367
              
              
              2,119Other
                  current assets
              
              
              555
              
              
              836Total
                  current assets
              
              
              31,461
              
              
              27,809Property
                  and equipment, net
              
              
              3,968
              
              
              4,071Other
                  assets, net
              
              
              592
              
              
              618Total
                  assets
              
              $
              36,021
              
              $
              32,498**Liabilities
                  and Shareholders’ Equity**Current
                  liabilities:Line
                  of credit
              
              $
              3,000
              
              $
              3,000Accounts
                  payable and accrued liabilities
              
              
              5,244
              
              
              5,894Accrued
                  compensation and related expenses
              
              
              1,657
              
              
              1,200Deferred
                  product revenues
              
              
              4,375
              
              
              4,484Deferred
                  services revenues
              
              
              15,805
              
              
              12,884Total
                  current liabilities
              
              
              30,081
              
              
              27,462Shareholders’
                  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; 16,074,841 issued
                  and
                  outstanding at September 30, 2005, 15,926,594
                  issued and outstanding at December 31, 2004
              
              
              161
              
              
              159Additional
                  paid-in capital
              
              
              65,738
              
              
              65,179Accumulated
                  deficit
              
              
              (59,959
              )
              
              (60,302
              )Total
                  shareholders’ equity
              
              
              5,940
              
              
              5,036Total
                  liabilities and shareholders’ equity
              
              $
              36,021
              
              $
              32,498
 
 See
        Accompanying Notes to Condensed Consolidated Financial
        Statements
  -3-
 Table
            of Contents
  
 **Interactive
        Intelligence, Inc.**
 **Condensed
        Consolidated Statements of Operations (unaudited)**
 **For
        the Three and Nine Months Ended September 30, 2005 and
        2004**
 **(in
        thousands, except per share amounts)**
 
 **Three
                  Months Ended**
                **September
                  30,**
              
              **Nine
                  Months Ended**
                **September
                  30,****2005**
              
              **2004**
              
              **2005**
              
              **2004**Revenues:Product
              
              $
              7,783
              
              $
              6,591
              
              $
              24,265
              
              $
              20,947Services
              
              
              7,405
              
              
              6,823
              
              
              21,138
              
              
              19,814Total
                  revenues
              
              
              15,188
              
              
              13,414
              
              
              45,403
              
              
              40,761Cost
                  of revenues:Product
              
              
              963
              
              
              452
              
              
              2,837
              
              
              1,451Services
              
              
              2,743
              
              
              2,564
              
              
              8,153
              
              
              8,088Total
                  cost of revenues
              
              
              3,706
              
              
              3,016
              
              
              10,990
              
              
              9,539Gross
                  profit
              
              
              11,482
              
              
              10,398
              
              
              34,413
              
              
              31,222Operating
                  expenses:Sales
                  and marketing
              
              
              6,188
              
              
              5,228
              
              
              18,188
              
              
              15,292Research
                  and development
              
              
              3,061
              
              
              3,208
              
              
              9,468
              
              
              9,744General
                  and administrative
              
              
              2,153
              
              
              1,860
              
              
              6,209
              
              
              5,666Total
                  operating expenses
              
              
              11,402
              
              
              10,296
              
              
              33,865
              
              
              30,702Operating
                  income
              
              
              80
              
              
              102
              
              
              548
              
              
              520Other
                  income (expense):Interest
                  income, net
              
              
              69
              
              
              28
              
              
              182
              
              
              60Other
                  income (expense)
              
              
              (74
              )
              
              10
              
              
              (256
              )
              
              82Total
                  other income (expense)
              
              
              (5
              )
              
              38
              
              
              (74
              )
              
              142Income
                  before income taxes
              
              
              75
              
              
              140
              
              
              474
              
              
              662Income
                  taxes
              
              
              47
              
              
              38
              
              
              131
              
              
              136Net
                  income
              
              $
              28
              
              $
              102
              
              $
              343
              
              $
              526Net
                  income per share:Basic
              
              $
              0.00
              
              $
              0.01
              
              $
              0.02
              
              $
              0.03Diluted
              
              
              0.00
              
              
              0.01
              
              
              0.02
              
              
              0.03Shares
                  used to compute net income per share:Basic
              
              
              16,054
              
              
              15,872
              
              
              16,009
              
              
              15,841Diluted
              
              
              16,928
              
              
              16,476
              
              
              16,730
              
              
              16,637
 
 See
        Accompanying Notes to Condensed Consolidated Financial
        Statements
  -4-
 Table
            of Contents
  
 **Interactive
        Intelligence, Inc.**
 **Condensed
        Consolidated Statement of Shareholders’ Equity (unaudited)**
 **For
        the Nine Months Ended September 30, 2005**
 **(in
        thousands)**
 
 **Common
                  Stock**
              
              **Additional**
                **Paid-in**
              
              **Accumulated****Shares**
              
              **Amount**
              
              **Capital**
              
              **Deficit**
              
              **Total**Balances,
                  December 31, 2004
              
              
              15,927
              
              $
              159
              
              $
              65,179
              
              $
              (60,302
              )
              $
              5,036Issuances
                  of common stock
              
              
              46
              
              
              1
              
              
              164
              
              
              --
              
              
              165Exercise
                  of stock options
              
              
              102
              
              
              1
              
              
              325
              
              
              --
              
              
              326Stock-based
                  compensation
              
              
              --
              
              
              --
              
              
              70
              
              
              --
              
              
              70Net
                  income
              
              
              --
              
              
              --
              
              
              --
              
              
              343
              
              
              343Balances,
                  September 30, 2005
              
              
              16,075
              
              $
              161
              
              $
              65,738
              
              $
              (59,959
              )
              $
              5,940
 
 See
        Accompanying Notes to Condensed Consolidated Financial
        Statements
  -5-
 Table
            of Contents
  
 **Interactive
        Intelligence, Inc.**
 **Condensed
        Consolidated Statements of Cash Flows (unaudited)**
 **For
        the Nine Months Ended September 30, 2005 and 2004**
 **(in
        thousands)**
 
 **Nine
                  Months Ended**
                **September
                  30,****2005**
              
              **2004****Operating
                  activities:**Net
                  income
              
              $
              343
              
              $
              526Adjustments
                  to reconcile net income to net cash provided by operatingactivities:Depreciation
              
              
              1,625
              
              
              2,383Amortization
                  of deferred stock-based compensation
              
              
              70
              
              
              8Changes
                  in operating assets and liabilities:Accounts
                  receivable
              
              
              (4,596
              )
              
              2,508Prepaid
                  expenses
              
              
              (248
              )
              
              245Other
                  current assets
              
              
              281
              
              
              (427
              )Other
                  assets
              
              
              26
              
              
              8Accounts
                  payable and accrued liabilities
              
              
              (650
              )
              
              1,043Accrued
                  compensation and related expenses
              
              
              457
              
              
              (219
              )Deferred
                  product revenues
              
              
              (109
              )
              
              (3,915
              )Deferred
                  services revenues
              
              
              2,921
              
              
              (444
              )Net
                  cash provided by operating activities
              
              
              120
              
              
              1,716**Investing
                  activities:**Purchases
                  of property and equipment
              
              
              (1,522
              )
              
              (1,116
              )Sales
                  of available-for-sale investments
              
              
              --
              
              
              3,008Net
                  cash provided (used) by investing activities
              
              
              (1,522
              )
              
              1,892**Financing
                  activities:**Payments
                  on line of credit, net
              
              
              --
              
              
              (800
              )Proceeds
                  from issuance of common stock
              
              
              165
              
              
              214Proceeds
                  from stock options exercised
              
              
              326
              
              
              163Net
                  cash provided (used) by financing activities
              
              
              491
              
              
              (423
              )Net
                  increase (decrease) in cash and cash equivalents
              
              
              (911
              )
              
              3,185Cash
                  and cash equivalents, beginning of period
              
              
              14,603
              
              
              12,461Cash
                  and cash equivalents, end of period
              
              $
              13,692
              
              $
              15,646Cash
                  paid for interest
              
              $
              9
              
              $
              18Cash
                  paid for taxes
              
              
              223
              
              
              2
 
 See
        Accompanying Notes to Condensed Consolidated Financial Statements
 
  -6-
 Table
            of Contents
  **Interactive
        Intelligence, Inc.**
 **Notes
        To Condensed Consolidated Financial Statements**
 **September
        30, 2005 and 2004 (unaudited)**
 
 **1.**
              **Description
                  of Business and Basis of
                  Presentation**
 
 Interactive
        Intelligence, Inc. (the “Company”) is a leading provider of software
        applications for contact centers and is leveraging that leadership position
        to
        provide mission critical voice over Internet protocol (VoIP) applications
        to
        enterprises. The Company sells into four distinct markets, all of whose needs
        are increasing for VoIP-based systems:
 ·
              Contact
                  Centers,
 ·
              Enterprise
                  IP Telephony,
 ·
              Unified
                  Communications, and
 ·
              Self-service
                  Automation.
 
 The
        Company’s principal competitors are hardware vendors who offer proprietary
        approaches using a combination of phone systems, call distributors, voice
        mail
        systems, and interactive voice response (IVR) systems equipment. The Company
        offers a software solution based on Microsoft Windows that resides on a
        customer’s network and uses an open Session Initiation Protocol (SIP) for VoIP
        networking. This open approach typically results in lower overall costs for
        phone devices, system maintenance, and customer networking. The Company’s
        software applications are also pre-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 customer interactions. The Company is best known
        for
        its bundled suite of contact center applications that includes multi-media
        customer contact for phone calls, Web chat, Web callback, e-mail queuing,
        customer defined queues, and integrated speech recognition applications.
 
 Principal
        operations of the Company commenced during 1997. Since then, the Company
        has
        established wholly-owned subsidiaries in Australia, France, the Netherlands
        and
        the United Kingdom, and in 2004 formed its Vonexus subsidiary for Global
        Enterprise IP Telephony and Microsoft small business customer markets. The
        Company also currently has branch offices in Canada, Germany, Hong Kong,
        Japan,
        Korea, Malaysia, Singapore and Sweden. The Company markets its software
        applications in the Americas, Europe, the Middle East and Africa (EMEA),
        and the
        Asia Pacific region (APAC).
 
 The
        accompanying unaudited financial statements have been prepared in conformity
        with accounting principles generally accepted in the United States of America
        for interim financial information and with the instructions for Form 10-Q
        and
        Article 10 of Regulation S-X. Accordingly, certain information and footnote
        disclosures normally included in financial statements prepared in accordance
        with accounting principles generally accepted in the United States of America
        have been condensed, or omitted, pursuant to the rules and regulations of
        the
        Securities and Exchange Commission. In our opinion, the statements include
        all
        adjustments necessary (which are of a normal and recurring nature) for the
        fair
        presentation of the results of the interim periods presented.
 
 The
        balance sheet at December 31, 2004 has been derived from the audited financial
        statements at that date but does not include all of the information and
        footnotes required by accounting principles generally accepted in the United
        States of America for complete financial statements.
 
 These
        financial statements should be read in conjunction with our audited consolidated
        financial statements for the year ended December 31, 2004, included in the
        Company’s Form 10-K for the year ended December 31, 2004 as filed with the
        Securities and Exchange Commission. Our results of operations for any interim
        period are not necessarily indicative of the results of operations for any
        other
        interim period or for a full fiscal year.
 
 **2.**
              **Net
                  Income Per Common Share**
 
 Basic
        net
        income per share is calculated based on the weighted-average number of
        outstanding common shares in accordance with Financial Accounting Standards
        Board (FASB) Statement No. 128, *Earnings
        per Share* .
        Diluted
        net income per share is calculated based on the weighted-average number of
        outstanding common shares plus the effect of dilutive potential common shares.
        Potential common shares are composed of shares of common stock issuable upon
        the
        exercise of stock options. The calculation of diluted net income per share
        excludes shares underlying outstanding stock options with exercise prices
        that
        exceed the average market price of the Company’s common stock for the period, as
        the effect would be antidilutive.
  -7-
 Table
            of Contents
  The
        following table presents the calculation of basic and diluted net income
        per
        share (in thousands, except per share amounts):
 
 **Three
                  Months Ended**
                **September
                  30,**
              
              **Nine
                  Months Ended**
                **September
                  30,****2005**
              
              **2004**
              
              **2005**
              
              **2004**Net
                  income, as reported (A)
              
              $
              28
              
              $
              102
              
              $
              343
              
              $
              526Weighted
                  average outstanding shares of common stock (B)
              
              
              16,054
              
              
              15,872
              
              
              16,009
              
              
              15,841Dilutive
                  effect of options to purchase common stock
              
              
              875
              
              
              604
              
              
              721
              
              
              796Common
                  stock and common stock equivalent shares (C)
              
              
              16,928
              
              
              16,476
              
              
              16,730
              
              
              16,637Net
                  income per share:Basic
                  (A/B)
              
              $
              0.00
              
              $
              0.01
              
              $
              0.02
              
              $
              0.03Diluted
                  (A/C)
              
              
              0.00
              
              
              0.01
              
              
              0.02
              
              
              0.03
 
 The
        Company’s calculation of diluted net income per share for the three months ended
        September 30, 2005 and 2004 excludes options to purchase 1.8 million and
        1.4
        million shares of common stock, respectively, and diluted net income per
        share
        for the nine months ended September 30, 2005 and 2004 excludes options to
        purchase 2.0 million and 1.7 million shares of common stock, respectively,
        as
        their effect would be antidilutive.
 
 **3.**  **Stock-Based
        Compensation**
 
 The
        Company applies the intrinsic-value-based method 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, an interpretation
        of APB
        Opinion No. 25* ,
        to
        account for its fixed-plan stock options. Under this method, compensation
        expense is recorded on the date of grant only if the current market price
        of the
        underlying stock exceeds the exercise price. FASB Statement No. 123, *Accounting
        for Stock-Based Compensation* and
        FASB
        Statement No. 148, *Accounting
        for Stock-Based Compensation - Transition and Disclosure - an amendment of
        FASB
        Statement No. 123* ,
        established accounting and disclosure requirements using a fair-value-based
        method of accounting for stock-based employee compensation plans. As permitted
        by existing accounting standards, the Company has elected to continue to
        apply
        the intrinsic-value-based method of accounting described above, and has adopted
        only the disclosure requirements of FASB Statements No. 123 and 148. See
        Note 7
        below for a discussion of upcoming changes to the accounting for stock-based
        compensation.
 
 For
        purposes of pro forma disclosures, the estimated fair value of the options
        is
        amortized to expense on a straight-line basis over the options’ vesting period.
        The table below illustrates the effect on net income (loss) and net income
        (loss) per share if the Company had applied the fair value recognition
        provisions of FASB Statement No. 123 to stock-based employee compensation
        (in
        thousands, except per share amounts).
 
 **Three
                  Months Ended**
                **September
                  30,**
              
              **Nine
                  Months Ended**
                **September
                  30,****2005**
              
              **2004**
              
              **2005**
              
              **2004**Net
                  income, as reported
              
              $
              28
              
              $
              102
              
              $
              343
              
              $
              526Add:
                  Stock-based compensation expense included in reported net income,
                  net of
                  related tax effects
              
              
              9
              
              
              --
              
              
              70
              
              
              8Deduct:
                  Total stock-based compensation expense determined under fair value
                  based
                  method for all awards, net of related tax effect
              
              
              (726
              )
              
              (990
              )
              
              (2,315
              )
              
              (2,602
              )Pro
                  forma net loss
              
              $
              (689
              )
              $
              (888
              )
              $
              (1,902
              )
              $
              (2,068
              )Net
                  income (loss) per share:Basic
                  - as reported
              
              $
              0.00
              
              $
              0.01
              
              $
              0.02
              
              $
              0.03Diluted
                  - as reported
              
              
              0.00
              
              
              0.01
              
              
              0.02
              
              
              0.03Basic
                  - pro forma
              
              
              (0.04
              )
              
              (0.06
              )
              
              (0.12
              )
              
              (0.13
              )Diluted
                  - pro forma
              
              
              (0.04
              )
              
              (0.06
              )
              
              (0.12
              )
              
              (0.13
              )
 
  -8-
 Table
            of Contents
  **4.**
              **Reclassifications**
 
 Beginning
        in the second quarter of 2005, the Company reclassified, for prior periods,
        certain foreign currency transaction gains and losses, as well as foreign
        tax
        withholdings, from sales and marketing, and general and administrative expenses,
        to other income (expense). In addition beginning in the second quarter of
        2005,
        the Company reclassified, for prior periods, certain hardware revenues
        and
        expenses from services to product. These reclassifications had no impact
        on the
        Company’s total consolidated results in any period presented.
 
 **5.**
              **Concentration
                  of Credit Risk**
 
 No
        resellers or customers had greater than 10% concentration of accounts receivable
        as of September 30, 2005 or as of December 31, 2004.
 
 **6.**
              **Contingencies**
 
 From
        time
        to time the Company has received claims from competitors and other technology
        providers claiming that the Company’s technology infringes their respective
        proprietary rights. One such claim has resulted in a legal proceeding being
        filed against the Company, which is described below. The Company cannot assure
        you that these matters can be resolved amicably without litigation, or that
        the
        Company will be able to enter into licensing arrangements on terms and
        conditions that would not have a material adverse effect on its business,
        financial condition or results of operations.
 
 On
        January 14, 2005, the Company entered into a non-exclusive license agreement
        with a telecommunication technology provider to use certain of its fax-related
        patents. Pursuant to this agreement, the Company has paid initial fees of
        $300,000 and paid 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, Recursion Software, Inc. filed suit in Dallas County
        Court
        in Dallas, Texas against the Company alleging breach of contract and money
        due
        under claims of quantum meruit and unjust enrichment. Recursion claims that
        the
        Company incorporated Recursion software into one of its products in breach
        of
        the underlying license. On November 3, 2003, the Company had the case removed
        to
        Federal District Court in Dallas, Texas and on January 28, 2004, Recursion
        asserted a copyright infringement claim against the Company, which was expanded
        in scope on September 10, 2004. No dollar amount has been stated in the action.
        The Company believes that it has strong defenses to the claims and intends
        to
        vigorously defend against the action. The Company believes that this matter
        can
        be resolved without a material adverse effect on its business, financial
        condition or results of operations; however, the Company cannot provide
        assurance as to the outcome.
 
 In
        November 2002, the Company received a notification from the French government
        as
        a result of a tax audit that had been conducted encompassing the years 1998,
        1999, 2000 and 2001. These assessments claim various taxes are owed related
        to
        Value Added Tax (VAT) and corporation taxes in addition to what has previously
        been paid and accrued. As of September 30, 2005, the assessment related to
        VAT
        was approximately $2.8 million and the assessment related to corporation
        taxes
        was approximately $361,500. The Company’s tax counsel has assessed the
        possibility of the Company paying the assessment related to VAT as remote
        and
        the assessment related to corporation taxes as reasonably possible. The Company
        has not accrued for these amounts. The Company is appealing the assessments,
        but
        cannot assure you that these matters will be resolved without litigation
        or that
        it will not have to pay some or all of the assessments. The Company has filed
        for VAT refunds of more than $600,000, to which the French government has
        not
        yet responded. The Company believes that these VAT refunds could be used
        to
        offset any money owed to the French government in connection with the
        assessments.
 
 From
        time
        to time, the Company is also involved in certain legal proceedings in the
        ordinary course of conducting its business. While the ultimate liability
        pursuant to these actions cannot currently be determined, the Company believes
        these legal proceedings will not have a material adverse effect on its financial
        position or results of operations. Litigation in general, and intellectual
        property litigation in particular, can be expensive and disruptive to normal
        business operations. Moreover, the results of complex legal proceedings are
        difficult to predict.
 
 **7.**
              **Recent
                  Accounting Pronouncements**
 
 In
        December 2004, the FASB issued FASB Statement No. 123R, *Share-Based
        Payment* ,
        which
        establishes standards for transactions in which an entity exchanges its equity
        instruments for goods or services. This standard requires a public entity
        to
        measure the cost of employee services received in exchange for an award of
        equity instruments based on the grant-date fair value of the award. This
        eliminates the exception to account for such awards using the intrinsic
        value-based method previously allowable under APB Opinion No. 25 (see Note
        3
        above). In March 2005, the Securities and Exchange Commission (SEC) released
        Staff Accounting Bulletin (SAB) 107, *Share-Based
        Payment* ,
        which
        expresses views of the SEC staff about the application of FASB Statement
        No.
        123R. FASB Statement No. 123R was to be 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. 123R will be effective for annual
        reporting periods beginning on or after June 15, 2005. The Company expects
        that
        the adoption will have a significant adverse impact on its consolidated net
        income and net income per share.
 
  -9-
 Table
            of Contents
  In
        December 2004, the FASB issued FASB Statement No. 153, *Exchanges
        of Nonmonetary Assets - an amendment of APB Opinion No. 29 (Accounting for
        Nonmonetary Transactions)* .
        FASB
        Statement No. 153 requires that exchanges of nonmonetary assets be measured
        based on the fair value of the assets exchanged. Further, it expands the
        exception for nonmonetary exchanges of similar productive assets to nonmonetary
        assets that do not have commercial substance. The provisions of FASB Statement
        No. 153 are effective for nonmonetary asset exchanges occurring in fiscal
        periods beginning after June 15, 2005. The adoption of the provisions of
        FASB
        Statement No. 153 is not expected to have a material impact on the Company’s
        consolidated financial position or results of operations.
  In
        December 2004, the FASB issued FASB Staff Position No. 109-1
        (FAS 109-1), *Application
        of FASB Statement No. 109,* Accounting
        for Income Taxes *,
        to
        the Tax Deduction on Qualified Production Activities Provided by the American
        Jobs Creation Act of 2004 (AJCA)* .
        The
        AJCA introduces a special phased in tax deduction, starting at 3%, on qualified
        production activities. FAS 109-1 clarifies that this tax deduction
        should
        be accounted for as a special tax deduction in accordance with FASB Statement
        No. 109. The Company does not expect the adoption of these new tax provisions
        to
        have a material impact on its consolidated financial position, results of
        operations or cash flows.
 In
          May
          2005, SFAS No. 154, *Accounting Changes and Error Corrections - a Replacement
          of APB Opinion No. 20 and FASB Statement No. 3,* was issued.  SFAS
          No. 154 requires retrospective application for voluntary changes in accounting
          principle unless impractical to do so.  Retrospective application
          refers to
          the application of a different accounting principle to previously issued
          financial statements as if that principle had always been used. 
          This
          Statement is effective for the Company’s fiscal year beginning January 1,
          2006.  The Company does not expect this Statement to have a
          material impact on its financial statements.
 **Item
                  2.**
              **Management’s
                  Discussion and Analysis of Financial Condition
                  and Results of Operations.**
 
 **Forward-Looking
        Information**
 
 Certain
        statements in this Form 10-Q contain "forward-looking" information
        (as
        defined in Section 27A of the Securities Act of 1933, as amended and
        Section 21E of the Securities Exchange Act of 1934, as amended) that
        involve risks and uncertainties which may cause actual results to differ
        materially from those predicted in the forward-looking statements.
        Forward-looking statements can often be identified by their use of such verbs
        as
        "expects," "anticipates," and "believes" or similar verbs or conjugations
        of
        such verbs. If any of our assumptions on which the statements are based prove
        incorrect or should unanticipated circumstances arise, our actual results
        could
        materially differ from those anticipated by such forward-looking statements.
        The
        differences could be caused by a number of factors or combination of factors,
        including, but not limited to, the "Certain factors that may affect our future
        operating results" described herein and the Risk Factors described in our
        Securities and Exchange Commission filings, including the Form 10-K
        filing
        for the year ended December 31, 2004.
 
 **Overview**
 
 We
        are a
        leading provider of software applications for contact centers and plan to
        leverage that leadership position to provide mission critical VoIP applications
        to enterprises. Our customers are in a wide variety of fields including
        financial institutions, government, healthcare and retail, among others.
        We are
        a global software provider with a presence in the Americas, Europe, Middle
        East
        and Africa (EMEA), and the Asia Pacific region (APAC).
 
 **Financial
        Highlights**
  For
        the
        nine months ended September 30, 2005 and the years ending December 31, 2004
        and
        2003 we saw a growth rate in revenues of 11%, 7% and 8%, respectively. Factors
        that affect revenues in any particular quarter include potential customers’
        budget constraints, personnel resources to implement the software, and
        willingness to implement a critical telecommunications system. As the table
        below shows, third quarter revenue growth is generally lower than in other
        quarters primarily due to seasonally lower order volume. Because the terms
        of a
        contract or prior payment experience with a customer or reseller affect revenue
        recognition, revenue recognition may occur in a period later than the period
        in
        which an order is received.
 
  -10-
 Table
            of Contents
  The
        information below shows our total revenues (in millions) for the most recent
        five quarters, the nine month periods ended September 30, 2005 and 2004,
        and the
        years ended December 31, 2004 and 2003 and the percentage change over the
        previous period.
 
 **Period**
              
              **Revenues**
              
              **%
                  Growth**Three
                  months ended:September
                  30, 2005
              
              $
              15.2
              
              
              (3
              )%June
                  30, 2005
              
              
              15.6
              
              
              7March
                  31, 2005
              
              
              14.6
              
              
              2December
                  31, 2004
              
              
              14.4
              
              
              7September
                  30, 2004
              
              
              13.4
              
              
              (2
              )Nine
                  months ended:September
                  30, 2005
              
              $
              45.4
              
              
              11
              %September
                  30, 2004
              
              
              40.8
              
              
              6Year
                  ended December 31:2004
              
              $
              55.1
              
              
              7
              %2003
              
              
              51.5
              
              
              8
 
 Our
        experience is that once organizations have implemented our software and their
        personnel experience the capabilities and efficiencies of our software, these
        organizations tend to expand their use, resulting in additional spending
        for our
        software. However, we cannot assure you that this will continue to be the
        case.
        Future licensing to new customers is dependent on competition, the economy
        and
        whether companies will allocate their resources to upgrade their systems.
 
 Total
        revenues recognized in the three and nine months ended September 30, 2005
        increased $1.8 million and $4.6 million, respectively, over revenues for
        the
        three and nine months ended September 30, 2004. Product revenues increased
        18%
        in the three months ended September 30, 2005 and services revenues increased
        9%.
        For the nine months ended September 30, 2005, product revenues increased
        16%,
        while services revenues increased 7%. Prior to 2004 the majority of license
        revenues were recognized under annually renewable licenses over the license
        term, generally one year. In the first quarter of 2004, we began offering
        perpetual licenses to our new customers and therefore the recognition of
        revenues on new contracts signed was accelerated compared to how revenues
        were
        recognized under annually renewable licenses. In the three and nine months
        ended
        September 30, 2005, 70% and 71%, respectively, of the product revenues
        recognized were related to perpetual license agreements compared to 50% and
        44%
        of the product revenues in the three and nine months ended September 30,
        2004,
        respectively.
 
 We
        formed
        a new subsidiary, Vonexus, on July 1, 2004. Vonexus is focused on selling
        a
        complete IP-based phone system, including hardware, to Microsoft-based small
        and
        medium-sized businesses. As a result of the formation of Vonexus and this
        new
        market focus, we have experienced higher expenses since the third quarter
        of
        2004, mainly in sales and marketing and in cost of product. In the first
        nine
        months of 2005, we began recognizing revenues related 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 do not expect
        these
        expenses to significantly increase compared to the first nine months of 2005.
        In
        the fourth quarter of 2005, we expect to record increasing revenues from
        Vonexus. We also expect to incur additional costs of revenues related to
        hardware costs for Vonexus and, as a consequence, if Vonexus sales become
        significant, our gross profit as a percentage of revenues may
        decline.
 
 Operating
        expenses for the three and nine months ended September 30, 2005 increased
        $1.1
        million and $3.2 million, respectively, compared to the three and nine months
        ended September 30, 2004. These increases were due to an increase in Vonexus
        sales and marketing as well as higher general and administrative expenses
        which
        increased primarily as a result of an increase in payroll expenses due to
        increased staffing and an increase in travel expenses, partially offset by
        lower
        depreciation and corporate insurance expense.
 
 We
        had
        $13.7 million of cash and cash equivalents as of September 30, 2005. We had
        borrowings under a line of credit of $3.0 million as of September 30, 2005,
        which have since been repaid in full. Cash decreased from $14.6 million as
        of
        December 31, 2004 due to lower than expected cash collections of accounts
        receivable which resulted in higher days sales outstanding at September 30,
        2005. We have made several organizational changes within our finance area
        to
        improve our billing and collections process. We expect that these changes
        will
        have a positive effect on our cash collections in the fourth quarter and
        beyond.
        We believe that if our revenues increase as expected in the fourth quarter,
        our
        accounts receivable are collected timely and our expenses remain controlled,
        we
        will improve our liquidity position in the fourth quarter.
  -11-
 Table
            of Contents
  
 **Historical
        Results of Operations**
  The
        following table presents certain financial data, derived from our unaudited
        statements of operations, as a percentage of total revenues for the periods
        indicated. The operating results for the three and nine months ended September
        30, 2005 and 2004 are not necessarily indicative of the results that may
        be
        expected for the full year or for any future period.
 
 **Three
                  Months Ended**
                **September
                  30,**
              
              **Nine
                  Months Ended**
                **September
                  30,****2005**
              
              **2004**
              
              **2005**
              
              **2004**Revenues:Product
              
              
              51
              %
              
              49
              %
              
              53
              %
              
              51
              %Services
              
              
              49
              
              
              51
              
              
              47
              
              
              49Total
                  revenues
              
              
              100
              
              
              100
              
              
              100
              
              
              100Cost
                  of revenues:Product
              
              
              6
              
              
              3
              
              
              6
              
              
              3Services
              
              
              18
              
              
              19
              
              
              18
              
              
              20Total
                  cost of revenues
              
              
              24
              
              
              22
              
              
              24
              
              
              23Gross
                  profit
              
              
              76
              
              
              78
              
              
              76
              
              
              77Operating
                  expenses:Sales
                  and marketing
              
              
              41
              
              
              39
              
              
              40
              
              
              38Research
                  and development
              
              
              20
              
              
              24
              
              
              21
              
              
              24General
                  and administrative
              
              
              14
              
              
              14
              
              
              14
              
              
              14Total
                  operating expenses
              
              
              75
              
              
              77
              
              
              75
              
              
              76Operating
                  income
              
              
              1
              
              
              1
              
              
              1
              
              
              1Other
                  income (expense):Interest
                  income, net
              
              
              --
              
              
              --
              
              
              --
              
              
              --Other
                  income (expense)
              
              
              (1
              )
              
              --
              
              
              --
              
              
              --Total
                  other income (expense)
              
              
              (1
              )
              
              --
              
              
              --
              
              
              --Income
                  before income taxes
              
              
              --
              
              
              1
              
              
              1
              
              
              1Income
                  taxes
              
              
              --
              
              
              --
              
              
              --
              
              
              --Net
                  income
              
              
              --
              %
              
              1
              %
              
              1
              %
              
              1
              %
 
 **Comparison
        of Three and Nine Months Ended September 30, 2005 and 2004**
  ***Revenues***
  *Product
        Revenues*
  **Three
                  Months Ended**
                **September
                  30,**
              
              **Nine
                  Months Ended**
                **September
                  30,****2005**
              
              **2004**
              
              **2005**
              
              **2004****($
                  in thousands)**Product
                  revenues
              
              $
              7,783
              
              $
              6,591
              
              $
              24,265
              
              $
              20,947Change
                  from prior year
              
              
              18
              %
              
              16
              %
              
              16
              %
              
              4
              %Percentage
                  of total revenues
              
              
              51
              %
              
              49
              %
              
              53
              %
              
              51
              %
 
 The
        increase in product revenues was primarily related to an increase in the
        number
        of software orders, Vonexus revenues which we began recognizing in 2005 and
        an
        increase in the percentage of perpetual license agreements we recognized
        in
        2005. Prior to 2004 the majority of license revenues were recognized under
        annually renewable licenses over the license term, generally one year. In
        the
        first quarter of 2004, we began offering perpetual licenses to our new customers
        and therefore the recognition of revenues on new contracts signed was
        accelerated compared to how revenues were recognized under annually renewable
        licenses. In the three and nine months ended September 30, 2005, 70% and
        71%,
        respectively, of the product revenues recognized were related to perpetual
        license agreements compared to 50% and 44% of the product revenues in the
        three
        and nine months ended September 30, 2004, respectively.
  -12-
 Table
            of Contents
  
 The
        aggregate dollar amount of orders, including Vonexus, increased 66% in the
        three
        months ended September 30, 2005 compared to the three months ended September
        30,
        2004, and increased 45% for the nine months ended September 30, 2005 compared
        to
        the nine months ended September 30, 2004.
 
 *Services
        Revenues*
  **Three
                  Months Ended**
                **September
                  30,**
              
              **Nine
                  Months Ended**
                **September
                  30,****2005**
              
              **2004**
              
              **2005**
              
              **2004****($
                  in thousands)**Services
                  revenues
              
              $
              7,405
              
              $
              6,823
              
              $
              21,138
              
              $
              19,814Change
                  from prior year
              
              
              9
              %
              
              6
              %
              
              7
              %
              
              7
              %Percentage
                  of total revenues
              
              
              49
              %
              
              51
              %
              
              47
              %
              
              49
              %
 
 Services
        revenues consist principally of support and license renewal fees. These revenues
        also include professional services, education and other revenues. Our services
        revenues should increase as we continue to sign and implement new customers
        and
        as existing customers continue to renew licenses and pay for support on our
        software applications.
 
 For
        the
        three months ended September 30, 2005, support and license renewal fee revenues
        increased $570,000 over the three months ended September 30, 2004, while
        other
        services revenues remained consistent. Services revenues increased $1.3 million
        for the nine months ended September 30, 2005 compared to the nine months
        ended
        September 30, 2004 due to maintenance revenues increasing by $2.6 million,
        partially offset by a decrease in professional services and education
        revenues.
  ***Cost
        of Revenues***
  **Three
                  Months Ended**
                **September
                  30,**
              
              **Nine
                  Months Ended**
                **September
                  30,****2005**
              
              **2004**
              
              **2005**
              
              **2004****($
                  in thousands)**Cost
                  of revenues:Product
              
              $
              963
              
              $
              452
              
              $
              2,837
              
              $
              1,451Services
              
              
              2,743
              
              
              2,564
              
              
              8,153
              
              
              8,088Total
                  cost of revenues
              
              $
              3,706
              
              $
              3,016
              
              $
              10,990
              
              $
              9,539Change
                  from prior year
              
              
              23
              %
              
              (6
              )%
              
              15
              %
              
              (7
              )%Product
                  costs as a % of product revenues
              
              
              12
              %
              
              7
              %
              
              12
              %
              
              7
              %Services
                  costs as a % of services revenues
              
              
              37
              %
              
              38
              %
              
              39
              %
              
              41
              %
 
 Costs
        of
        product consist primarily of product and software royalties paid to third
        parties for the use of their technologies in our products, hardware costs
        and,
        to a lesser extent, software packaging costs, which include product media,
        duplication and documentation. Costs of product can fluctuate depending on
        which
        software applications are licensed to our customers, the third party technology,
        if any, which is licensed and the dollar amount of Vonexus systems licensed.
        The
        increase in the product costs for the three and nine months ended September
        30,
        2005 compared to the three and nine months ended September 30, 2004 was due
        to
        Vonexus hardware costs and an increase in royalties paid to third party software
        providers.
 
 Costs
        of
        services consist primarily of compensation expenses for technical support,
        education and professional services personnel and other costs associated
        with
        supporting our resellers and customers. These costs increased almost 7% for
        the
        three months ended September 30, 2005 compared to the three months ended
        September 30, 2004 due to an increase in employee related expenses such as
        compensation and travel, partially offset by a decrease in subcontracted
        services. Costs of services remained relatively constant for the nine months
        ended September 30, 2005 compared to the nine months ended September 30,
        2004.
   ***Gross
        Profit***
  **Three
                  Months Ended**
                **September
                  30,**
              
              **Nine
                  Months Ended**
                **September
                  30,****2005**
              
              **2004**
              
              **2005**
              
              **2004****($
                  in thousands)**Gross
                  profit
              
              $
              11,482
              
              $
              10,398
              
              $
              34,413
              
              $
              31,222Change
                  from prior year
              
              
              10
              %
              
              17
              %
              
              10
              %
              
              10
              %Percentage
                  of total revenues
              
              
              76
              %
              
              78
              %
              
              76
              %
              
              77
              %
 
 -13-
 Table
            of Contents
 The
        increase in the dollar amount of gross profit was primarily the result of
        an
        increase in product and services revenues, partially offset by the smaller
        increase in cost of revenues discussed above. The decrease in the gross profit
        percentage for the three and nine months ended September 30, 2005 compared
        to
        the three and nine months ended September 30, 2004, was due to increases
        in
        product costs as described above.
  ***Operating
        Expenses***
  *Sales
        and Marketing*
  **Three
                  Months Ended**
                **September
                  30,**
              
              **Nine
                  Months Ended**
                **September
                  30,****2005**
              
              **2004**
              
              **2005**
              
              **2004****($
                  in thousands)**Sales
                  and marketing expenses
              
              $
              6,188
              
              $
              5,228
              
              $
              18,188
              
              $
              15,292Change
                  from prior year
              
              
              17
              %
              
              4
              %
              
              18
              %
              
              1
              %Percentage
                  of total revenues
              
              
              41
              %
              
              39
              %
              
              40
              %
              
              38
              %Percentage
                  of product revenues
              
              
              80
              %
              
              79
              %
              
              75
              %
              
              73
              %
 
 Sales
        and
        marketing expenses are comprised primarily of compensation expense, travel,
        marketing and entertainment expenses. As anticipated and discussed in our
        Form
        10-K for the year ended December 31, 2004 and in our previous Form 10-Q reports
        for 2005, these expenses increased primarily due to payroll expenses and
        other
        costs associated with Vonexus, our wholly-owned subsidiary. In addition,
        marketing salaries and marketing expenses increased due to expanded
        marketing activities for both Interactive Intelligence and Vonexus
        products.
 
 As
        described previously under Financial Highlights, we do not expect these Vonexus
        operating costs to increase significantly compared to the first nine months
        of
        2005, and we expect to record increased revenues from Vonexus in the fourth
        quarter.
 
 *Research
        and Development*
  **Three
                  Months Ended**
                **September
                  30,**
              
              **Nine
                  Months Ended**
                **September
                  30,****2005**
              
              **2004**
              
              **2005**
              
              **2004****($
                  in thousands)**Research
                  and development expenses
              
              $
              3,061
              
              $
              3,208
              
              $
              9,468
              
              $
              9,744Change
                  from prior year
              
              
              (5
              )%
              
              (3
              )%
              
              (3
              )%
              
              (5
              )%Percentage
                  of total revenues
              
              
              20
              %
              
              24
              %
              
              21
              %
              
              24
              %
 
 Research
        and development expenses are comprised primarily of compensation and
        depreciation expenses. Research and development expenses decreased due to
        lower
        depreciation expense as certain of our assets become fully depreciated and
        a
        decrease in outsourced services related to the translation of our products
        into
        different languages.
 
 *General
        and Administrative*
  **Three
                  Months Ended**
                **September
                  30,**
              
              **Nine
                  Months Ended**
                **September
                  30,****2005**
              
              **2004**
              
              **2005**
              
              **2004****($
                  in thousands)**General
                  and administrative expenses
              
              $
              2,153
              
              $
              1,860
              
              $
              6,209
              
              $
              5,666Change
                  from prior year
              
              
              16
              %
              
              20
              %
              
              10
              %
              
              30
              %Percentage
                  of total revenues
              
              
              14
              %
              
              14
              %
              
              14
              %
              
              14
              %
 
 General
        and administrative expenses are comprised of compensation expense and
        non-allocable expenses including bad debt, legal and other professional fees.
        The increase for the three months ended September 30, 2005 compared to the
        three
        months ended September 30, 2004 was due to an increase in professional services
        relating to increased legal fees.
 
 The
        increase for the nine months ended September 30, 2005 compared to the nine
        months ended September 30, 2004 was the result of higher payroll expenses
        due to
        increased staffing, an increase in other office expenses and an increase
        in bad
        debt expense, offset partially by lower depreciation expenses and lower expense
        for corporate insurance.
  -14-
 Table
            of Contents
 ***Other
        Income (Expense)***
  *Interest
        Income, net*
 **Three
                    Months Ended**
                  **September
                    30,**
                
                **Nine
                    Months Ended**
                  **September
                    30,****2005**
                
                **2004**
                
                **2005**
                
                **2004****($
                    in thousands)**Cash,
                    cash equivalents and short-term investments (average)
                
                $
                13,666
                
                $
                15,326
                
                $
                14,148
                
                $
                14,054Interest
                    income
                
                
                70
                
                
                31
                
                
                191
                
                
                78Return
                    on investment
                
                
                2.0
                %
                
                0.8
                %
                
                2.7
                %
                
                1.1
                %
 Interest
        income, net is primarily comprised of interest earned from investments and
        interest-bearing cash accounts. Interest expense and fees, which were not
        material for any periods reported, are also included in interest income,
        net.
        Interest earnings improved during the three and nine months ended September
        30,
        2005 compared to the three and nine months ended September 30, 2004 as shown
        above. The improvement was related mainly to a change in the funds that we
        invested in. The new funds have a higher interest rate and lower
        fees.
  *Other
        Income (Expense)*
 **Three
                    Months Ended**
                  **September
                    30,**
                
                **Nine
                    Months Ended**
                  **September
                    30,****2005**
                
                **2004**
                
                **2005**
                
                **2004****($
                    in thousands)**Other
                    income (expense)
                
                $
                (74
                )
                $
                10
                
                $
                (256
                )
                $
                82
 Beginning
        with the three
        months ended June 30, 2005, we began classifying our foreign currency
        transaction gains and losses, as well as foreign tax withholdings, in other
        income (expense) instead of sales and marketing and general and administrative
        expenses. All prior periods have been reclassified to this presentation.
        These
        amounts depend on the amount of revenue that is generated in certain
        international currencies, principally the Euro, and the exchange gain or
        loss
        that results from foreign currency disbursements and receipts.
  **Liquidity
        and Capital Resources**
  We
        generate cash from the collections we receive related to licensing our
        application software and from annual license renewals, maintenance and support
        and other services revenues. We also have in place a $3.0 million line of
        credit, which we fully utilized as of September 30, 2005, all of which was
        repaid in full subsequent to September 30, 2005. We use cash primarily for
        paying our employees (including salaries, commissions and benefits), leasing
        office space, reimbursing travel expenses, paying insurance premiums and
        paying
        vendors for services rendered and supplies purchased.
 
 We
        determine liquidity by combining cash and cash equivalents and short-term
        investments net of our line of credit borrowings as shown in the table below.
        Our total liquidity position as of September 30, 2005 declined compared with
        our
        position as of December 31, 2004 due mainly to lower than expected cash
        collections of accounts receivable . We did not have any short-term investments
        at September 30, 2005 or December 31, 2004. We believe that our current
        liquidity position, when combined with our anticipated cash flows from
        operations, will be sufficient to satisfy our operating cash needs over the
        next
        12 months. If cash flows from operations are less than anticipated or we
        have
        additional cash needs (such as an unfavorable outcome in legal proceedings),
        our
        liquidity may not be sufficient to cover our needs. In this case, we may
        be
        forced to raise additional capital, either through the capital markets or
        debt
        financings. We may not be able to receive favorable terms in raising this
        capital.
 
 **September
                  30,**
              
              **December
                  31,****2005**
              
              **2004****($
                  in thousands)**Cash
                  and cash equivalents
              
              $
              13,692
              
              $
              14,603Line
                  of credit
              
              
              (3,000
              )
              
              (3,000
              )Liquidity,
                  net
              
              $
              10,692
              
              $
              11,603
 
 Our
        operating activities resulted in net cash provided of $120,000 and $1.7 million
        for the nine months ended September 30, 2005 and 2004, respectively. This
        decrease in net cash provided was primarily a result of an increased amount
        of
        accounts receivable (a total difference in the net change of $7.1 million)
        and a
        decrease in accounts payable and other accrued liabilities, partially offset
        by
        lower depreciation and a net increase in services revenues.
 
 The
        amount that we report as cash and cash equivalents or as temporary investments
        fluctuates depending on investing practices in each period. Purchases of
        short-term investments are reported as a use of cash and the related receipt
        of
        proceeds upon maturity of the investment is reported as a source of
        cash.
 
 We
        purchased property and equipment with a cost of $1.5 million and $1.1 million
        in
        the nine months ended September 30, 2005 and 2004, respectively. These purchases
        related mainly to in-house technology and leasehold improvements for our
        corporate headquarters.
  -15-
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 Deferred
        revenues are comprised of deferred product revenues and deferred services
        revenues. Deferred services revenues increased $2.9 million as of September
        30,
        2005 compared to December 31, 2004, due primarily to an increase in renewal
        billings from our growing customer base and a decrease in cash collections,
        which affected the recognition of our services revenues.
 
 **Critical
        Accounting Policies and Estimates**
  We
        believe there are three accounting policies that are important to understanding
        our historical and future performance, as these policies affect the reported
        amounts of revenues and are the 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 described below.
 
 ***Sources
        of Revenues and Revenue Recognition Polic*** ***y***
 
 We
        generate product revenues from licensing the right to use our software
        applications and generate services revenues primarily from annual renewal
        fees,
        annual maintenance fees, educational services and professional services.
        We
        believe both of these sources of revenues are critical to our financial
        statements because of their materiality to our statements as a whole and
        because
        of the judgment required in determining if revenue recognition criteria have
        been met.
 
 *Product
        Revenues*
  Our
        software license agreements are either annually renewable or perpetual. For
        any
        revenues to be recognized from a software license agreement, the following
        criteria must be met:
 ·
              persuasive
                  evidence of an arrangement exists;
 ·
              the
                  fee is fixed or determinable;
 ·
              collection
                  is probable; and
 ·
              delivery
                  has occurred.
 
 For
        an
        annually renewable software license agreement, upon meeting the revenue
        recognition criteria above, we recognize a majority of the initial license
        fees
        under these agreements as product revenues ratably over the initial license
        period, which is generally 12 months, and the remainder of the initial license
        fees are recognized as services revenues over the same time period.
 
 For
        a
        perpetual software license agreement, upon meeting the revenue recognition
        criteria above, we immediately recognize as product revenues the amount of
        initial license fees if sufficient vendor specific objective evidence exists
        to
        support allocating a portion of the total fee to the undelivered elements
        of the
        arrangement. If sufficient vendor specific objective evidence of the fair
        value
        of the undelivered elements does not exist, we recognize the initial license
        fee
        as product revenues ratably over the initial term of the maintenance agreement,
        which is generally 12 months but at times may be more than 12 months because
        maintenance begins when the licenses are downloaded which is typically within
        six months of the contract date.
 
 *Services
        Revenues*
  Services
        revenues are recognized for annually renewable software license agreements
        and
        perpetual software license agreements. In the initial year of the contract,
        the
        allocation of the initial order between product revenues and services revenues
        is based on the actual renewal fee for perpetual licenses and based on an
        estimated percentage for annually renewable software license agreements.
        After
        the initial license period, our customers may renew their license agreement
        for
        an additional period, typically 12 months, by paying a renewal fee. We recognize
        annual maintenance fees as services revenues ratably over the post-contract
        maintenance period, which is typically 12 months.
 
 We
        also
        generate revenues from other services that we provide to our resellers and
        customers. These additional revenues include fees for educational services
        and
        professional services. Revenues from educational services, which consist
        of
        training courses for resellers and customers, and professional services,
        which
        include implementing our products for a customer, are recognized as the related
        services are performed.
  -16-
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   ***Allowance
        for Doubtful Accounts Receivable***
  We
        adjust
        our allowance for doubtful accounts for each reporting period based on an
        average bad debt expense to revenue ratio and based on a detailed analysis
        of
        our accounts receivable at the end of that period. In estimating the allowance
        for doubtful accounts, we primarily consider the age of the reseller’s or
        customer's receivable and also consider the creditworthiness of the reseller
        or
        customer, the economic conditions of the customer's industry, and general
        economic conditions, among other factors. If payment is not made timely,
        we
        contact the customer or reseller to try to obtain payment. If this is not
        successful, we institute other collection practices such as generating
        collection letters, involving our sales representatives and ultimately
        terminating the customer’s or reseller’s access to future upgrades, licenses and
        customer support. Once all collection efforts are exhausted, the receivable
        is
        written off against the allowance for doubtful accounts.
  We
        experienced an increase in accounts receivable days sales outstanding at
        September 30, 2005 compared to prior quarters. We made several organizational
        changes within our finance area, with certain of these changes occurring
        after
        the end of the quarter, to improve our billing and collections process.
  ***Research
        and Development***
  Through
        September 30, 2005, all research and development expenditures have been expensed
        as incurred. Based on our product development process and technological
        feasibility, the date at which capitalization of development costs may begin
        is
        established upon completion of a working model. Costs incurred between
        completion of the working model and the point at which the product is ready
        for
        general release have been insignificant.
 
 **Certain
        factors that may affect our future operating results are set forth below:**
 
 **THE
        OVERALL ECONOMIC CLIMATE MAY BE WEAK**
  Our
        products typically represent substantial capital commitments by customers
        and
        involve a potentially long sales cycle. As a result, customer purchase decisions
        may be significantly affected by a variety of factors, including general
        economic trends in the allocation of capital 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 their capital spending related to information systems.
        If the economy weakens, demand for our products could decrease, resulting
        in
        lower revenues.
 
 **WE
        HAVE HISTORICALLY INCURRED LOSSES AND WE MAY NOT SUSTAIN PROFITABILITY**
 
 At
        September 30, 2005, we had accumulated net losses since inception of
        $60.0 million. We incurred net losses of $5.9 million and $7.7 million
        in
        2003 and 2002, respectively. Since the first quarter of 2004, we have reported
        net income; however, we may not do so again in the future. We intend to continue
        to make significant investments in our research and development, marketing,
        services, sales operations and our new subsidiary, Vonexus. In addition,
        as
        discussed in Note 7 of Notes to Consolidated Financial Statements, FASB
        Statement No. 123R will have an adverse effect on our operating results when
        we
        implement it. As a result, we may experience losses in future quarters.
 
 **OUR
        QUARTERLY OPERATING RESULTS HAVE VARIED SIGNIFICANTLY**
 
 Our
        operating results have varied significantly from quarter to quarter and may
        continue to do so in the future depending on a number of factors affecting
        us or
        our industry, including many that are beyond our control. As a result, we
        believe that period-to-period comparisons of our operating results are not
        necessarily meaningful, and you should not rely on them as an indication
        of our
        future performance. In addition, our operating results in a future quarter
        or
        quarters may fall below expectations of securities analysts or investors
        and, as
        a result, the price of our common stock may fluctuate.
 
 Because
        we do not know if or when our potential customers will place orders and finalize
        licenses, and because it is difficult to predict the mix of annually renewable
        licenses and perpetual licenses in a quarter, we cannot accurately forecast
        our
        licensing activity, our revenues and our operating results for future quarters.
        We recognize revenues from different licenses over different periods depending
        on the satisfaction of the requirements of relevant accounting literature,
        including AICPA Statement of Position 97-2, Statement of Position 98-9, SEC
        Staff Accounting Bulletin (SAB) 104, and all related AICPA Technical Practice
        Aids (5100.38 - 5100.76). As a result, our quarterly revenues
        and
        operating results depend on many factors, including the type of license,
        the
        size, quantity and timing of orders received for our products during each
        quarter, the delivery of the related software and our expectations regarding
        collection. If a large number of orders or several large orders do not occur
        or
        are deferred or delayed, our revenues in a quarter could be substantially
        reduced. This risk is heightened by the significant investment and executive
        level decision-making typically involved in our customers' decisions to license
        our products. Since a large portion of our operating expenses, including
        salaries and rent, is fixed and difficult to reduce or modify in a short
        time
        period, our business, financial condition or results of operations could
        be
        materially adversely affected if revenues do not meet our expectations.
  -17-
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 Our
        limited number of products, changes in pricing policies, the timing of
        development completion, and announcement and sale of new or upgraded versions
        of
        our products are some of the additional factors that could cause our revenues
        and operating results to vary significantly from quarter to
        quarter.
  **WE
        HAVE A LENGTHY PRODUCT SALES CYCLE WHICH HAS CONTRIBUTED AND MAY CONTINUE
        TO
        CONTRIBUTE TO THE VARIABILITY OF QUARTERLY OPERATING RESULTS**
 
 We
        have
        generally experienced a lengthy product sales cycle, averaging approximately
        six
        to nine months. The lengthy sales cycle is one of the factors that has caused,
        and may in the future continue to cause, our product revenues and operating
        results to vary significantly from quarter to quarter, which could affect
        the
        market price of our common stock. The lengthy sales cycle also makes it
        difficult for us to forecast product license revenues. Because of the unique
        characteristics of our products, our prospective customers' decisions to
        license
        our products often require significant investment and executive-level decision
        making. We believe that many companies currently are not aware of the benefits
        of interaction management software of the type that we license or of our
        products and capabilities. For this reason, we must provide a significant
        level
        of education to prospective customers about the use and benefits of our
        products, which can cause potential customers to take many months to make
        these
        decisions. As a result, sales cycles for customer orders vary substantially
        from
        customer to customer. Excessive delay in product sales could materially
        adversely affect our business, financial condition or results of operations.
 
 The
        length of the sales cycle for customer orders depends on a number of other
        factors over which we have little or no control, including:
 ·
              a
                  customer's budgetary constraints;
 ·
              the
                  timing of a customer's budget cycles;
 ·
              concerns
                  by customers about the introduction of new products by us or our
                  competitors; and
 ·
              downturns
                  in general economic conditions, including reductions in demand
                  for contact
                  center services.
 
 **OUR
        INABILITY TO SUCCESSFULLY MANAGE OUR INCREASINGLY COMPLEX THIRD PARTY
        RELATIONSHIPS COULD ADVERSELY AFFECT US**
 
 As
        the
        complexity of our product technology and our reseller and other third party
        relationships have increased, the management of those relationships and the
        negotiation of contractual terms sufficient to protect our rights and limit
        our
        potential liabilities have become more complicated, and we expect this trend
        to
        continue in the future. In addition, the formation of our wholly-owned
        subsidiary, Vonexus, which offers through resellers a whole product solution,
        has added complexity to those third party relationships. As a result, our
        inability to successfully manage these relationships or negotiate sufficient
        contractual terms could have a material adverse effect on us.
 
 **WE
        FACE COMPETITIVE PRESSURES, WHICH MAY HAVE A MATERIAL ADVERSE EFFECT ON US**
 
 The
        market for our software applications is highly competitive and, because there
        are relatively low barriers to entry in the software market, we expect
        competitive pressures to continue to be a risk to our ongoing success in
        the
        market. In addition, because our industry is evolving and characterized by
        rapid
        technological change, it is difficult for us to predict whether, when and
        by
        whom new competing technologies or new competitors may be introduced into
        our
        markets. Currently, our competition comes from several different market
        segments, including computer telephony platform developers, computer telephony
        applications software developers and telecommunications equipment vendors.
        We
        cannot provide assurance that we will be able to compete effectively against
        current and future competitors. In addition, increased competition or other
        competitive pressures may result in price reductions, reduced margins or
        loss of
        market share, any of which could have a material adverse effect on our business,
        financial condition or results of operations.
 
 Many
        of
        our current and potential competitors have longer operating histories,
        significantly greater resources, greater name recognition 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 and changes in customer requirements
        more effectively than we can, or to devote greater resources to the development,
        promotion and sale of products than we can. In addition, for a number of
        our
        larger competitors, the product segment in which they currently compete with
        us
        is a small portion of their overall offering. These competitors might be
        willing
        and able to dramatically cut prices in our segment in order to protect or
        grow
        other segments that are more important to their overall business. Current
        and
        potential competitors have established, and may in the future establish,
        cooperative relationships among themselves or with third parties, including
        mergers or acquisitions, to increase the ability of their products to address
        the needs of our current or prospective customers. If these competitors were
        to
        acquire significantly increased market share, it could have a material adverse
        effect on our business, financial condition or results of operations.
  -18-
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            of Contents
  
 **WE
        MAY NOT BE ABLE TO GROW OUR BUSINESS IF WE DO NOT MAINTAIN SUCCESSFUL
        RELATIONSHIPS WITH OUR RESELLERS AND PARTNERS AND CONTINUE TO RECRUIT AND
        DEVELOP ADDITIONAL SUCCESSFUL RESELLERS AND PARTNERS**
 
 Our
        ability to achieve revenue growth in the future will depend in part on our
        success in maintaining successful relationships with our existing and future
        resellers and partners and in recruiting and training additional resellers
        and
        partners. We rely primarily on resellers to market and support our products
        and
        plan on continuing to rely heavily on such partners in the future. We are
        still
        developing our reseller and distribution networks and may be unable to attract
        additional resellers with both voice and data expertise or appropriate partners
        that will be able to market our products effectively and that will be qualified
        to provide timely and cost-effective customer support and service. We generally
        do not have long-term or exclusive agreements with our resellers or partners,
        and the loss of specific larger resellers or partners or a significant number
        of
        resellers or partners could materially adversely affect our business, financial
        condition or results of operations.
 
 **OUR
        MARKETS ARE CHARACTERIZED BY RAPID TECHNOLOGICAL CHANGE WHICH MAY CAUSE US
        TO
        INCUR SIGNIFICANT DEVELOPMENT COSTS AND PREVENT US FROM ATTRACTING NEW
        CUSTOMERS**
  The
        market for our products is characterized by rapid technological change, frequent
        new product introductions and enhancements, uncertain product life cycles
        and
        changing customer demands. The introduction of products embodying new
        technologies and the emergence of new industry standards could render existing
        products obsolete or unmarketable and cause us to incur significant development
        costs and prevent us from attracting new customers.
 
 **A
        DECLINE IN MARKET ACCEPTANCE FOR MICROSOFT TECHNOLOGIES ON WHICH OUR PRODUCTS
        RELY COULD HAVE A MATERIAL ADVERSE EFFECT ON US**
 
 Our
        products currently run only on Microsoft Windows operating systems. In addition,
        our products use other Microsoft technologies, including Microsoft Exchange
        Server and Microsoft SQL Server. A decline in market acceptance for Microsoft
        technologies or the increased acceptance of other server technologies could
        cause us to incur significant development costs and could have a material
        adverse effect on our ability to market our current products. Although we
        believe that Microsoft technologies will continue to be widely used by
        businesses, we cannot assure you that businesses will adopt these technologies
        as anticipated or will not in the future migrate to other competing technologies
        that we do not currently support. In addition, our products and technologies
        must continue to be compatible with new developments in Microsoft technologies.
  **OUR
        FUTURE BUSINESS PROSPECTS DEPEND IN PART ON OUR ABILITY TO MAINTAIN AND IMPROVE
        OUR CURRENT PRODUCTS AND DEVELOP NEW PRODUCTS**
 
 We
        believe that our future business prospects depend in large part on our ability
        to maintain and improve our current software applications and to develop
        new
        software applications on a timely basis. Our software applications will have
        to
        continue to achieve market acceptance, maintain technological competitiveness
        and meet an expanding range of customer requirements. As a result of the
        complexities inherent in our applications, major new applications and
        application enhancements require long development and testing periods. We
        may
        not be successful in developing and marketing, on a timely and cost effective
        basis, application enhancements or new software applications that respond
        to
        technological change, evolving industry standards or customer requirements.
        We
        may also experience difficulties that could delay or prevent the successful
        development, introduction or marketing of application enhancements, and our
        new
        applications and application enhancements may not achieve market acceptance.
        Significant delays in the general availability of new releases of our software
        applications or significant problems in the installation or implementation
        of
        new releases of our applications could have a material adverse effect on
        our
        business, financial condition or results of operations.
 
 **SLOW
        GROWTH, OR A DECLINE IN DEMAND FOR INTERACTION MANAGEMENT SOFTWARE OF THE
        TYPE
        WE LICENSE, COULD MATERIALLY ADVERSELY AFFECT OUR FINANCIAL RESULTS AND GROWTH
        PROSPECTS**
 
 If
        the
        demand for interaction management software of the type we license does not
        grow
        within each of our four targeted markets, our financial results and ability
        to
        grow our business could be materially adversely affected. Our revenues have
        been
        generated from licenses of our Interaction Center Platform software or
        complementary products, and related support, educational and professional
        services. We expect these products and services to account for the majority
        of
        our revenues for the foreseeable future. Although we believe demand for the
        functions performed by our products is high, the market for our products
        and
        services is still emerging. Further, our growth plans require us to successfully
        attract enterprise and service provider customers in significantly larger
        numbers than we have historically achieved.
  -19-
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  **IF
        OUR CUSTOMERS DO NOT PERCEIVE OUR PRODUCTS OR THE RELATED SERVICES PROVIDED
        BY
        US OR OUR RESELLERS OR PARTNERS TO BE EFFECTIVE OR OF HIGH QUALITY, OUR BRAND
        AND NAME RECOGNITION WILL SUFFER**
 
 We
        believe that establishing and maintaining brand and name recognition is critical
        for attracting, retaining and expanding customers in our target markets.
        We also
        believe that the importance of reputation and name recognition will increase
        as
        competition in our market increases. Promotion and enhancement of our name
        will
        depend on the effectiveness of our marketing and advertising efforts and
        on our
        success in providing high-quality products and related services, neither
        of
        which can be assured. If our customers do not perceive our products or related
        services to be effective or of high quality, our brand and name recognition
        would suffer which could have a material adverse effect on our business,
        financial condition or results of operations.
 
 **WE
        MAY NOT BE ABLE TO PROTECT OUR PROPRIETARY RIGHTS ADEQUATELY, WHICH COULD
        ALLOW
        THIRD PARTIES TO COPY OR OTHERWISE OBTAIN AND USE OUR TECHNOLOGY WITHOUT
        AUTHORIZATION**
 
 We
        regard
        our software products as proprietary. In an effort to protect our proprietary
        rights, we rely primarily on a combination of copyright, trademark and trade
        secret laws, as well as patents, licensing and other agreements with
        consultants, suppliers, strategic and partners, resellers and customers,
        and
        employee and third-party non-disclosure agreements. These laws and agreements
        provide only limited protection of our proprietary rights. It may be possible
        for a third party to copy or otherwise obtain and use our technology without
        authorization. A third party could also develop similar technology
        independently. In addition, the laws of some countries in which we license
        our
        products do not protect our software and intellectual property rights to
        the
        same extent as the laws of the United States. Unauthorized copying, use or
        reverse engineering of our products could materially adversely affect our
        business, results of operations or financial condition.
  We
        license technology that is embedded in our products. If one or more of these
        licenses terminates or cannot be renewed on satisfactory terms, we would
        have to
        modify the affected products to use alternative technology or eliminate the
        affected product function, either of which could have a material adverse
        effect
        on us.
 
 **INFRINGEMENT
        CLAIMS COULD ADVERSELY AFFECT US**
 
 Third
        parties have claimed or may in the future claim that our technology infringes
        their proprietary rights. As the number of software products in our target
        markets increases and the functionality of these products overlap, we believe
        that software developers may face additional infringement claims. See
        Note 6 of Notes to Condensed Consolidated Financial Statements for
        a
        description of contingencies.
 
 Infringement
        claims, even if without merit, can be time consuming and expensive to defend.
        A
        third party asserting infringement claims against us or our customers with
        respect to our current or future products may require us to enter into costly
        royalty arrangements or litigation, or otherwise materially adversely affect
        us.
 
 **WE
        DEPEND ON KEY PERSONNEL AND WILL NEED TO RETAIN AND RECRUIT SKILLED PERSONNEL,
        FOR WHICH COMPETITION IS INTENSE, TO CONDUCT AND GROW OUR BUSINESS EFFECTIVELY**
 
 Our
        success depends in large part on the continued service of our key personnel,
        particularly Dr. Donald E. Brown, our Chief Executive Officer and
        principal
        stockholder. The loss of the services of Dr. Donald E. Brown or other
        key
        personnel could have a material adverse effect on our business, financial
        condition or results of operations. Our future success also depends on our
        ability to attract, train, assimilate and retain additional qualified personnel.
        Competition for persons with skills in the software industry is intense,
        particularly for those with relevant technical and/or sales experience. We
        cannot assure you that we will be able to retain our key employees or that
        we
        can attract, train, assimilate or retain other highly qualified personnel
        in the
        future.
 
  -20-
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  **WE
        MAY PURSUE ACQUISITIONS THAT BY THEIR NATURE PRESENT RISKS AND THAT MAY NOT
        BE
        SUCCESSFUL**
 
 In
        the
        future we may pursue acquisitions to diversify our product offerings and
        customer base or for other strategic purposes. We have no prior history of
        making material acquisitions and we cannot assure you that any future
        acquisitions will be successful. The following are some of the risks associated
        with acquisitions that could have a material adverse effect on our business,
        financial condition or results of operations:
 ·
              We
                  cannot assure that any acquired businesses will achieve anticipated
                  revenues, earnings or cash flow.
 ·
              We
                  may be unable to integrate acquired businesses successfully and
                  realize
                  anticipated economic, operational and other benefits in a timely
                  manner,
                  particularly if we acquire a business in a market in which we have
                  limited
                  or no current expertise, or with a corporate culture different
                  from our
                  own. If we are unable to integrate acquired businesses successfully,
                  we
                  could incur substantial costs and delays or other operational,
                  technical
                  or financial problems.
 ·
              Acquisitions
                  could disrupt our ongoing business, distract management, divert
                  resources
                  and make it difficult to maintain our current business standards,
                  controls
                  and procedures.
 ·
              We
                  may finance future acquisitions by issuing common stock for some
                  or all of
                  the purchase price. This could dilute the ownership interests of
                  our
                  stockholders. We may also incur additional debt or be required
                  to
                  recognize expense related to intangible assets recorded in future
                  acquisitions.
 ·
              We
                  may be competing with other firms, many of which have greater financial
                  and other resources, to acquire attractive companies, making it
                  more
                  difficult to acquire suitable companies on acceptable terms.
 
 **OUR
        INTERNATIONAL OPERATIONS INVOLVE FINANCIAL AND OPERATIONAL
        RISKS**
  Our
        international operations require significant management attention and financial
        resources to establish and operate, including hiring appropriate personnel
        and
        recruiting effective international resellers. Non-North American revenues
        accounted for 25%, 22% and 13% of our total revenues for the nine months
        ended
        September 30, 2005 and the years ended December 31, 2004 and 2003, respectively.
        We have marketing efforts in the Americas, EMEA and APAC. We intend to continue
        to emphasize our international operations and we may enter additional
        international markets. Revenues from international operations may be inadequate
        to cover the expenses of those operations. In addition to foreign currency
        fluctuation risks, other risks inherent in our international business activities
        may include the following:
 ·
              economic
                  and political instability;
 ·
              unexpected
                  changes in foreign regulatory requirements and laws;
 ·
              tariffs
                  and other trade barriers;
 ·
              timing,
                  cost and potential difficulty of adapting our software products
                  to the
                  local language in those foreign countries that do not use the alphabet
                  that English uses, such as Japan, Korea and China;
 ·
              lack
                  of acceptance of our products in foreign countries;
 ·
              longer
                  sales cycles and accounts receivable payment cycles;
 ·
              potentially
                  adverse tax consequences;
 ·
              restrictions
                  on the repatriation of funds;
 ·
              acts
                  of terrorism; and
 ·
              increased
                  government regulations related to increasing or reducing business
                  activity
                  in various countries.
 
 **FLUCTUATIONS
        IN THE VALUE OF FOREIGN CURRENCIES COULD RESULT IN LOSSES**
 
 Our
        international revenues are generally denominated in U.S. dollars with the
        exception of some European resellers and customers located in countries that
        have adopted the Euro as their official currency. Our international expenses
        are
        generally denominated in local foreign currencies. Although foreign currency
        transaction gains and losses have not been significant to date, fluctuations
        in
        exchange rates between the U.S. dollar and other currencies could have a
        material adverse effect on our business, financial condition or results of
        operations, and particularly on our net income. To date, we have minimally
        sought to hedge the risks associated with fluctuations in exchange rates,
        but we
        may more actively undertake to do so in the future. Any hedging techniques
        we
        implement in the future may not be successful. Exchange rate fluctuations
        could
        also make our products more expensive than competitive products not subject
        to
        these fluctuations, which could adversely affect our revenues and profitability
        in international markets.
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 **OUR
        PRODUCTS COULD HAVE DEFECTS FOR WHICH WE ARE POTENTIALLY LIABLE AND WHICH
        COULD
        RESULT IN LOSS OF REVENUE, INCREASED COSTS, LOSS OF OUR CREDIBILITY OR DELAY
        IN
        ACCEPTANCE OF OUR PRODUCTS IN THE MARKET**
 
 Our
        products, including components supplied by others, may contain errors or
        defects, especially when first introduced or when new versions are released.
        Despite internal product testing, we have in the past discovered software
        errors
        in some of our products after their introduction. Errors in new products
        or
        releases could be found after commencement of commercial shipments, and this
        could result in additional development costs, diversion of technical and
        other
        resources from our other development efforts, or the loss of credibility
        with
        current or future customers. This could result in a loss of revenue or delay
        in
        market acceptance of our products, which could have a material adverse effect
        on
        our business, financial condition or results of operations.
 
 Our
        license agreements with our customers typically contain provisions designed
        to
        limit our exposure to potential product liability and some contract claims.
        However, not all of these agreements contain these types of provisions and,
        where present, these provisions vary as to their terms and may not be effective
        under the laws of some jurisdictions. A product liability, warranty, or other
        claim brought against us could have a material adverse effect on our business,
        financial condition or results of operations.
 
 Our
        software runs on a Windows 2000 or Windows 2003 server and for telephone
        call
        processing uses voice processing boards or third party VoIP media processing
        software such as Intel HMP software. Our server software also operates in
        a
        complex network environment with database servers, email servers and other
        third
        party systems. Performance interruptions at our customer sites, most of which
        currently do not have back-up systems, could affect demand for our products
        or
        give rise to claims against us.
 
 **WE
        MAY NOT BE ABLE TO OBTAIN ADEQUATE FINANCING TO IMPLEMENT OUR STRATEGY**
 
 Successful
        implementation of our strategy may require continued access to capital. If
        we do
        not generate sufficient cash from operations, our growth could be limited
        unless
        we are able to obtain capital through additional debt or equity financings.
        We
        cannot assure you that debt or equity financings will be available as required
        for acquisitions or other needs. Even if financing is available, it may not
        be
        on terms that are favorable to us or sufficient for our needs. If we are
        unable
        to obtain sufficient financing, we may be unable to fully implement our growth
        strategy.
 
 **OUR
        STOCK PRICE HAS BEEN AND COULD CONTINUE TO BE HIGHLY VOLATILE**
 
 Our
        stock
        price has been and could continue to be highly volatile due to a number of
        factors, including:
 ·
              actual
                  or anticipated fluctuations in our operating results;
 ·
              announcements
                  by us, our competitors or our customers;
 ·
              changes
                  in financial estimates of securities analysts or investors regarding
                  us,
                  our industry or our competitors;
 ·
              technological
                  innovations by others;
 ·
              the
                  operating and stock price performance of other comparable companies
                  or of
                  our competitors;
 ·
              the
                  low number of our shares typically traded in any trading session;
 ·
              the
                  availability for future sale, or sales, of a substantial number
                  of shares
                  of our common stock in the public market; and
 ·
              general
                  market or economic conditions.
 
 This
        risk
        may be heightened because our industry is relatively new and evolving,
        characterized by rapid technological change and susceptible to the introduction
        of new competing technologies or competitors.
 
 In
        addition, the stock market has experienced significant price and volume
        fluctuations that have particularly affected the trading prices of equity
        securities of many technology companies, including us. These price and volume
        fluctuations often have been unrelated to the operating performance of the
        affected companies. In the past, following periods of volatility in the market
        price of a company's securities, securities class action litigation has often
        been instituted against that company. This type of litigation, regardless
        of the
        outcome, could result in substantial costs and a diversion of management's
        attention and resources, which could materially and adversely affect our
        business, financial condition or results of operations.
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 **OUR
        COMMON STOCK IS SUBJECT TO VARIOUS LISTING REQUIREMENTS**
 
 The
        various markets operated by The NASDAQ Stock Market have quantitative
        maintenance criteria for continued listing of common stock. We may be delisted
        from one or more NASDAQ markets if we fail to comply with the criteria. While
        we
        believe that we currently meet criteria for listing on a market operated
        by The
        NASDAQ Stock Market, we can offer no assurance that our common stock will
        continue to meet the various criteria for continued listing on any market
        operated by The NASDAQ Stock Market. Any delisting may result in a reduction
        in
        the liquidity of our common stock, which may have a material adverse effect
        on
        the price of our common stock.
 
 **REGULATORY
        CHANGES MADE TO GENERALLY ACCEPTED ACCOUNTING PRINCIPLES OR CORPORATE GOVERNANCE
        MATTERS MAY IMPACT OUR BUSINESS**
 
 Revisions
        to generally accepted accounting principles will require us to review our
        accounting and financial reporting procedures in order to ensure continued
        compliance with required policies. From time to time, such changes may have
        a
        short-term impact on our reporting, and these changes may impact market
        perception of our financial condition. In addition, legislative changes,
        and the
        perception these changes create, can have a material, adverse effect on our
        business. For example:
 ·
              pending
                  or new legislation, such as the Sarbanes-Oxley 404 regulations,
                  may lead
                  to an increase in our costs related to audits in particular and
                  regulatory
                  compliance generally; and
 ·
              changes
                  in the legal climate may lead to additional liability concerns
                  which may
                  result in increased insurance costs.
 
 **OUR
        EXECUTIVE OFFICERS AND DIRECTORS CONTROL US AND MAY MAKE DECISIONS THAT
        SHAREHOLDERS DO NOT CONSIDER TO BE IN THEIR BEST INTERESTS**
 
 Our
        current directors and executive officers together beneficially own more than
        50%
        of our outstanding common stock. Accordingly, these shareholders are able
        to
        control us through their ability to determine the outcome of the election
        of our
        directors, amend our Restated Articles of Incorporation and By-Laws and take
        other actions requiring the vote or consent of shareholders, including mergers,
        going private transactions and other 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 of our board of directors.
 
 **ANTI-TAKEOVER
        PROVISIONS IN OUR ORGANIZATIONAL DOCUMENTS AND INDIANA LAW MAKE ANY CHANGE
        IN
        CONTROL OF US MORE DIFFICULT, MAY DISCOURAGE BIDS AT A PREMIUM OVER THE MARKET
        PRICE AND MAY ADVERSELY AFFECT THE MARKET PRICE OF OUR
        STOCK**
 
 Our
        Restated Articles of Incorporation and By-Laws contain provisions that may
        have
        the effect of delaying, deferring or preventing a change in control of us,
        may
        discourage bids at a premium over the market price of our common stock and
        may
        adversely affect the market price of our common stock, and the voting and
        other
        rights of the holders of our common stock. These provisions
        include:
 ·
              the
                  division of our board of directors into three classes serving staggered
                  three-year terms;
 ·
              removal
                  of directors only for cause and only upon a 66 2/3% shareholder
                  vote;
 ·
              prohibiting
                  shareholders from calling a special meeting of
                  shareholders;
 ·
              the
                  ability to issue additional shares of our common stock or preferred
                  stock
                  without shareholders’ approval; and
 ·
              advance
                  notice requirements for raising business or making nominations
                  at
                  shareholders’ meetings.
 
 The
        Indiana corporation law contains business combination provisions that, in
        general, prohibit for five years any business combination with a beneficial
        owner of 10% or more of our common stock unless the holder’s acquisition of the
        stock was approved in advance by our board of directors. The Indiana corporation
        law also contains control share acquisition provisions that limit the ability
        of
        certain shareholders to vote their shares unless their control share acquisition
        was approved in advance.
 
 **WE
        CANNOT PREDICT EVERY EVENT AND CIRCUMSTANCE THAT MAY IMPACT OUR BUSINESS
        AND,
        THEREFORE, THE RISKS AND UNCERTAINTIES DISCUSSED ABOVE MAY NOT BE THE ONLY
        ONES
        YOU SHOULD CONSIDER**
 
 The
        risks
        and uncertainties discussed above are 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 we are not aware at this time. These additional
        risks may cause serious damage to our business in the future, the impact
        of
        which we cannot estimate at this time.
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 **Item
        3. Quantitative and Qualitative Disclosures about Market
        Risk.**
  We
        develop products in the United States and license our products in the Americas,
        EMEA and APAC. As a result, our financial results could be affected by various
        factors, including changes in foreign currency exchange rates or weak economic
        conditions in foreign markets. As most sales are currently made in U.S. dollars,
        a strengthening of the dollar could make our products less competitive in
        foreign markets. Additionally, as our business matures in foreign markets,
        we
        may offer our products and services in certain other local currencies. As
        a
        result, we will be subject to foreign currency fluctuations, which may have
        an
        adverse affect on our company.
 
 We
        manage
        our interest rate risk by maintaining an investment portfolio with debt
        instruments of high credit quality and relatively short average maturities.
        We
        also manage interest rate risk by maintaining sufficient cash and cash
        equivalent balances such that we are typically able to hold our investments
        to
        maturity. We have a line of credit with a variable interest rate based upon
        the
        bank’s prime rate on which we incur interest expense when the line is
        utilized.
 
 **Item
        4. Controls and Procedures.**
 
 We
        maintain a set of disclosure controls and procedures that are designed to
        ensure
        that information required to be disclosed by us in the reports filed by us
        under
        the Securities Exchange Act of 1934, as amended (Exchange Act) is recorded,
        processed, summarized and reported within the time periods specified in the
        SEC’s rules and forms. We carried out an evaluation, under the supervision and
        with the participation of our management, including our President and Chief
        Executive Officer and our Chief Financial Officer and Treasurer, of the
        effectiveness of the design and operation of our disclosure controls and
        procedures as of September 30, 2005 pursuant to Rule 13a-15(b) of the Exchange
        Act. Based on that evaluation, our President and Chief Executive Officer
        and our
        Chief Financial Officer and Treasurer concluded that our disclosure controls
        and
        procedures were effective.
 
 There
        have been no changes in our internal control over financial reporting that
        occurred during the quarter ended September 30, 2005 that have materially
        affected, or are reasonably likely to materially affect, our internal control
        over financial reporting.
 
 P **ART
        II. OTHER INFORMATION**
 
 **Item
        1. Legal Proceedings.**
 From
        time
        to time we have received claims from competitors and other technology providers
        claiming that our technology infringes their proprietary rights. One such
        claim
        has resulted in a legal proceeding being filed against us, which is described
        below. We cannot assure you that these matters can be resolved amicably without
        litigation, or that we will be able to enter into licensing arrangements
        on
        terms and conditions that would not have a material adverse effect on our
        business, financial condition or results of operations.
 
 On
        September 30, 2003, Recursion Software, Inc. filed suit in Dallas County
        Court
        in Dallas, Texas against us alleging breach of contract and money due under
        claims of quantum meruit, unjust enrichment and infringement. Recursion claims
        that we incorporated Recursion software into one of our products in breach
        of
        the underlying license. On November 3, 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 was expanded in scope on
        September 10, 2004. No dollar amount has been stated in the action. We believe
        that we have strong defenses to the claims and intend to vigorously defend
        against the action. We believe that this matter can be resolved without a
        material adverse effect on our business, financial condition or results of
        operations; however, we cannot provide assurance as to the outcome.
 
 In
        November 2002, we received a notification from the French government as a
        result
        of a tax audit that had been conducted encompassing the years 1998, 1999,
        2000
        and 2001. These assessments claim various taxes are owed related to Value
        Added
        Tax (VAT) and corporation taxes in addition to what has previously been paid
        and
        accrued. As of September 30, 2005, the assessment related to VAT was
        approximately $2.8 million and the assessment related to corporation taxes
        was
        approximately $361,500. Our tax counsel has assessed the possibility of us
        paying the assessment related to VAT as remote and the assessment related
        to
        corporation taxes as reasonably possible. We have not accrued for these amounts.
        We are appealing the assessments, but cannot assure you that these matters
        will
        be resolved without litigation or that we will not have to pay some or all
        of
        the assessments. We have filed for VAT refunds of more than $600,000, to
        which
        the French government has not yet responded. We believe that these VAT refunds
        could be used to offset any money owed to the French government in connection
        with the assessments.
 
 From
        time
        to time, we are also involved in certain intellectual property claims and
        legal
        proceedings in the ordinary course of conducting our business. While the
        ultimate liability pursuant to these actions cannot currently be determined,
        we
        believe these claims and legal proceedings will not have a material adverse
        effect on our business, financial condition or results from operations.
        Litigation in general, and intellectual property litigation in particular,
        can
        be expensive and disruptive to normal business operations. Moreover, the
        results
        of complex legal proceedings are difficult to predict.
 
  -24-
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  **Item
        6. Exhibits.**
 
 (a)
              Exhibits
 
 3.1  Restated
        Articles of Incorporation of the Company (incorporated herein by reference
        from
        the same exhibit number to the Company’s Registration Statement on Form S-1
        (Registration No. 333-79509))
 
 3.2  By-Laws
        of the Company, as amended to date (incorporated herein by reference from
        the
        same exhibit number to the Company’s Registration Statement on Form S-1
        (Registration No. 333-79509))
 
 31.1  Certification
        of the Chief Executive Officer pursuant to Rule 13a-14(a)/15d-14(a) of the
        Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the
        Sarbanes-Oxley Act of 2002
 
 31.2  Certification
        of the Chief Financial Officer pursuant to Rule 13a-14(a)/15d-14(a) of the
        Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the
        Sarbanes-Oxley Act of 2002
 
 32.1  Certification
        of Donald E. Brown, M.D., CEO, pursuant to 18 U. S. C. Section 1350, as adopted
        pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
 
 32.2  Certification
        of Stephen R. Head, CFO, pursuant to 18 U. S. C. Section 1350, as adopted
        pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
 
 
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 **SIGNATURES**
 
 Pursuant
        to the requirements of the Securities Exchange Act of 1934, the Registrant
        has
        duly caused this report to be signed on its behalf by the undersigned thereunto
        duly authorized.
 
 Interactive
                  Intelligence, Inc.(Registrant)Date:
                  November 14, 2005
              By/s/
                  Stephen R. HeadStephen
                  R. Head*Chief
                  Financial Officer, Vice President of Finance and**Administration,
                  Secretary and Treasurer**(Principal
                  Financial Officer and Principal Accounting
                  Officer)*
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