**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 March 31, 2007**
 
 **Or**
 
 **o**
              **TRANSITION
                  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
                  ACT OF
                  1934**
 
 **For
        the transition period from ____________to____________**
 
 **Commission
        File Number 000-27385**
   **INTERACTIVE
        INTELLIGENCE, INC.**
 **(Exact
        name of registrant as specified in its charter)**
 
 **Indiana**
                (State
                  or Other Jurisdiction
                of
                  Incorporation)
              
              **35-1933097**
                (IRS
                  Employer Identification No.)**7601
                  Interactive Way**
                **Indianapolis,
                  IN 46278**
                (Address
                  of Principal Executive Offices, including Zip Code)**(317)
                  872-3000**
                (Registrant’s
                  telephone number, including area code)
 
 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  **T**  No  *****
  Indicate
        by check mark whether the registrant is a large accelerated filer, an
        accelerated filer or a non-accelerated filer. See definition of “accelerated
        filer and large accelerated filer" as defined in Rule 12b-2 of the Exchange
        Act.  Large
        accelerated filer  *****    Accelerated
        filer **T**   Non-accelerated
        filer  *****
  Indicate
        by check mark whether the registrant is a shell company (as defined in Rule
        12b-2 of the Exchange Act).  Yes  *****  No  **T**
 
 As
          of
          April 30, 2007, there were 17,370,992 shares outstanding of the registrant’s
          common stock, $0.01 par value.
    
 
 TABLE
        OF
        CONTENTS
 
 
 PART
                  I. FINANCIAL INFORMATION
              **Page**Item
                  1.
              Financial
                  Statements.Condensed
                  Consolidated Balance Sheets as of March 31, 2007 and
                  December 31, 2006
              2Condensed
                  Consolidated Statements of Income for the three
                  months ended March 31, 2007 and 2006
              3Condensed
                  Consolidated Statement of Shareholders’ Equity for
                  the three months ended March 31, 2007
              4Condensed
                  Consolidated Statements of Cash Flows for the three
                  months ended March 31, 2007 and 2006
              5Notes
                  to Condensed Consolidated Financial
                  Statements
              6Item
                  2.
              Management’s
                  Discussion and Analysis of Financial Condition
                  and Results of Operations.
              11Item
                  3.
              Quantitative
                  and Qualitative Disclosures About Market
                  Risk.
              21Item
                  4.
              Controls
                  and Procedures.
              21PART
                  II. OTHER INFORMATIONItem
                  1.
              Legal
                  Proceedings.
              21Item
                  1A.
              Risk
                  Factors.
              22Item
                  6.
              Exhibits.
              22SIGNATURES
              23
 
 
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  **PART
        I. FINANCIAL INFORMATION**
 
 **Item
        1. Condensed Consolidated Financial Statements and** **Notes
        to Condensed Consolidated Financial Statements** **.**
 
 **I** **nteracti****ve
        Intelligence, Inc.**
 **Condensed
        Consolidated Balance Sheets**
 **As
        of March 31, 2007 and December 31, 2006**
 **(in
        thousands, except share and per share amounts)**
 
 **March
                  31,**
                **2007**
              
              **December
                  31,**
                **2006****(unaudited)**
              
              **(Note
                  1)****Assets**Current
                  assets:Cash
                  and cash equivalents
              
              $
              22,516
              
              $
              13,531Short-term
                  investments
              
              
              8,997
              
              
              13,555Accounts
                  receivable, net of allowance for doubtful accounts of $596 in 2007
                  and
                  2006
              
              
              18,578
              
              
              21,370Deferred
                  tax assets, net
              
              
              1,314
              
              
              1,314Prepaid
                  expenses
              
              
              5,645
              
              
              5,358Other
                  current assets
              
              
              2,336
              
              
              1,818Total
                  current assets
              
              
              59,386
              
              
              56,946Property
                  and equipment, net
              
              
              6,204
              
              
              5,469Deferred
                  tax assets, net
              
              
              3,686
              
              
              3,686Other
                  assets, net
              
              
              663
              
              
              674Total
                  assets
              
              $
              69,939
              
              $
              66,775**Liabilities
                  and Shareholders’ Equity**Current
                  liabilities:Accounts
                  payable and accrued liabilities
              
              $
              7,987
              
              $
              7,885Accrued
                  compensation and related expenses
              
              
              2,892
              
              
              3,825Deferred
                  product revenues
              
              
              5,565
              
              
              5,910Deferred
                  services revenues
              
              
              26,157
              
              
              24,877Total
                  current liabilities
              
              
              42,601
              
              
              42,497Shareholders’
                  equity:Preferred
                  stock, no par value: 10,000,000 shares authorized; no shares issued
                  and
                  outstanding
              
              
              --
              
              
              --Common
                  stock, $0.01 par value: 100,000,000 shares authorized; 17,361,143
                  issued
                  and outstanding at March 31, 2007 and 17,139,804 issued and outstanding
                  at
                  December 31, 2006
              
              
              173
              
              
              171Additional
                  paid-in capital
              
              
              73,918
              
              
              72,528Accumulated
                  deficit
              
              
              (46,753
              )
              
              (48,421
              )Total
                  shareholders’ equity
              
              
              27,338
              
              
              24,278Total
                  liabilities and shareholders’ equity
              
              $
              69,939
              
              $
              66,775
  See
        Accompanying Notes to Condensed Consolidated Financial Statements
 
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 **I** **nteractiv****e
        Intelligence, Inc.**
 **Condensed
        Consolidated Statements of Income (unaudited)**
 **For
        the Three Months Ended March 31, 2007 and 2006**
 **(in
        thousands, except per share amounts)**
 
 **Three
                  Months Ended**
                **March
                  31,****2007**
              
              **2006**Revenues:Product
              
              $
              12,261
              
              $
              8,861Services
              
              
              11,932
              
              
              9,069Total
                  revenues
              
              
              24,193
              
              
              17,930Cost
                  of revenues:Product
              
              
              2,441
              
              
              1,333Services
              
              
              4,797
              
              
              3,063Total
                  cost of revenues
              
              
              7,238
              
              
              4,396Gross
                  profit
              
              
              16,955
              
              
              13,534Operating
                  expenses:Sales
                  and marketing
              
              
              8,644
              
              
              6,879Research
                  and development
              
              
              3,897
              
              
              3,122General
                  and administrative
              
              
              3,065
              
              
              2,534Total
                  operating expenses
              
              
              15,606
              
              
              12,535Operating
                  income
              
              
              1,349
              
              
              999Other
                  income (expense):Interest
                  income, net
              
              
              472
              
              
              104Other
                  expense, net
              
              
              (56
              )
              
              (52
              )Total
                  other income, net
              
              
              416
              
              
              52Income
                  before income taxes
              
              
              1,765
              
              
              1,051Income
                  tax expense
              
              
              (97
              )
              
              (39
              )Net
                  income
              
              $
              1,668
              
              $
              1,012Net
                  income per share:Basic
              
              $
              0.10
              
              $
              0.06Diluted
              
              
              0.09
              
              
              0.06Shares
                  used to compute net income per share:Basic
              
              
              17,247
              
              
              16,251Diluted
              
              
              19,236
              
              
              17,178
  See
        Accompanying Notes to Condensed Consolidated Financial
        Statements
 
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 **Interac****tive
        Intelligence, Inc.**
 **Condensed
        Consolidated Statement of Shareholders’ Equity (unaudited)**
 **For
        the Three Months Ended March 31, 2007**
 **(in
        thousands)**
 
 **Common
                  Stock**
              
              **Additional**
                **Paid-in**
              
              **Accumulated****Shares**
              
              **Amount**
              
              **Capital**
              
              **Deficit**
              
              **Total**Balances,
                  December 31, 2006
              
              
              17,139
              
              $
              171
              
              $
              72,528
              
              $
              (48,421
              )
              $
              24,278Issuances
                  of common stock
              
              
              3
              
              
              --
              
              
              50
              
              
              --
              
              
              50Exercise
                  of stock options
              
              
              219
              
              
              2
              
              
              672
              
              
              --
              
              
              674Stock-based
                  compensation
              
              
              --
              
              
              --
              
              
              668
              
              
              --
              
              
              668Net
                  income
              
              
              --
              
              
              --
              
              
              --
              
              
              1,668
              
              
              1,668Balances,
                  March 31, 2007
              
              
              17,361
              
              $
              173
              
              $
              73,918
              
              $
              (46,753
              )
              $
              27,338
  See
        Accompanying Notes to Condensed Consolidated Financial Statements
 
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 **Interacti****ve
        Intelligence, Inc.**
 **Condensed
        Consolidated Statements of Cash Flows (unaudited)**
 **For
        the Three Months Ended March 31, 2007 and 2006**
 **(in
        thousands)**
 
 **Three
                  Months Ended**
                **March
                  31,****2007**
              
              **2006****Operating
                  activities:**Net
                  income
              
              $
              1,668
              
              $
              1,012Adjustments
                  to reconcile net income to net cash provided by operating
                  activities:Depreciation
              
              
              573
              
              
              430Accretion
                  of investment income
              
              
              (153
              )
              
              --Stock-based
                  compensation expense related to stock options
              
              
              668
              
              
              493Loss
                  on disposal of fixed assets
              
              
              --
              
              
              2Changes
                  in operating assets and liabilities:Accounts
                  receivable
              
              
              2,792
              
              
              797Prepaid
                  expenses
              
              
              (287
              )
              
              (1,049
              )Other
                  current assets
              
              
              (518
              )
              
              (146
              )Other
                  assets
              
              
              11
              
              
              (9
              )Accounts
                  payable and accrued liabilities
              
              
              102
              
              
              (109
              )Accrued
                  compensation and related expenses
              
              
              (933
              )
              
              (153
              )Deferred
                  product revenues
              
              
              (345
              )
              
              735Deferred
                  services revenues
              
              
              1,280
              
              
              1,308Net
                  cash provided by operating activities
              
              
              4,858
              
              
              3,311**Investing
                  activities:**Purchases
                  of property and equipment
              
              
              (1,308
              )
              
              (488
              )Purchases
                  of available-for-sale investments
              
              
              (3,454
              )
              
              (1,227
              )Sales
                  of available-for-sale investments
              
              
              8,165
              
              
              --Net
                  cash provided by (used in) investing activities
              
              
              3,403
              
              
              (1,715
              )**Financing
                  activities:**Proceeds
                  from issuance of common stock
              
              
              50
              
              
              57Proceeds
                  from stock options exercised
              
              
              674
              
              
              862Net
                  cash provided by financing activities
              
              
              724
              
              
              919Net
                  increase in cash and cash equivalents
              
              
              8,985
              
              
              2,515Cash
                  and cash equivalents, beginning of period
              
              
              13,531
              
              
              11,551Cash
                  and cash equivalents, end of period
              
              $
              22,516
              
              $
              14,066Cash
                  paid for interest
              
              $
              --
              
              $
              3Cash
                  paid for taxes
              
              
              27
              
              
              93
  See
        Accompanying Notes to Condensed Consolidated Financial
        Statements
 
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 **Interactive****Intelligence,
        Inc.**
 **Notes
        To Condensed Consolidated Financial Statements**
 **March
        31, 2007 and 2006 (unaudited)**
 
 **1.**
              **THE
                  COMPANY**
  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’s products are installed at international corporations,
        public agencies, telecommunication companies, distributed organizations,
        government and commercial enterprises. The Company participates in four distinct
        markets, all of whose needs are increasing for VoIP-based systems:
  ·
              Contact
                  Centers
  ·
              Enterprise
                  IP Telephony
  ·
              Enterprise
                  Messaging
  ·
              Self-Service
                  Automation
  The
        Company commenced principal operations in 1994 and revenues were first
        recognized in 1997. Since then, the Company has established wholly-owned
        subsidiaries in Australia, France, the Netherlands and the United Kingdom.
        The
        Company also currently has international branch offices in Canada, Germany,
        Japan, Korea, Malaysia, Singapore and Sweden. The Company markets its software
        applications in the Americas, Europe, the Middle East and Africa, and
        Asia/Pacific.
 
 The
        accompanying unaudited Condensed Consolidated 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 (the “SEC”). In
        the Company’s opinion, the Condensed Consolidated Financial 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
        accompanying Condensed Consolidated Balance Sheet at December 31, 2006 has
        been
        derived from the audited Consolidated 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
        Condensed Consolidated Financial Statements should be read in conjunction
        with
        the Company’s audited Consolidated Financial Statements for the year ended
        December 31, 2006, included in the Company’s Annual Report on Form 10-K for the
        year ended December 31, 2006 as filed with the SEC. The Company’s results of
        operations for any interim period are not necessarily indicative of the results
        of operations for any other interim period or for a full fiscal year.
 
 **2.**
              **SUMMARY
                  OF SIGNIFICANT ACCOUNTING
                  POLICIES**
 
 *Principles
        of Consolidation*
  The
        accompanying consolidated financial statements include the accounts of the
        Company and its wholly-owned subsidiaries after elimination of all significant
        intercompany accounts and transactions.
 
 *Use
        of Estimates*
 
 The
        preparation of consolidated financial statements in conformity with accounting
        principles generally accepted in the United States requires management to
        make
        estimates and assumptions that affect the amounts reported in the financial
        statements and accompanying notes. Despite management’s best effort to establish
        good faith estimates and assumptions, actual results could differ from these
        estimates.
 
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 **Interactive****Intelligence,
          Inc.**
 **Notes
          To Condensed Consolidated Financial Statements**
 **March
          31, 2007 and 2006 (unaudited)**
  *Revenue
        Recognition*
 
 The
        Company generates product revenues from licensing the right to use its software
        applications and in certain instances providing hardware as a component of
        its
        solution, and generates services revenues primarily from annual support fees,
        annual renewal fees, professional services and educational services.
 
 *Product
        Revenues*
 
 The
        Company’s license agreements are either perpetual or annually renewable. For any
        revenues to be recognized from a 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
        a
        perpetual license agreement, upon meeting the revenue recognition criteria
        above, the Company immediately recognizes as product revenues the amount
        of
        initial license fees if sufficient vendor specific objective evidence of
        fair
        value (“VSOE”) exists to support allocating a portion of the total fee to the
        undelivered elements of the arrangement. If sufficient VSOE of the
        undelivered elements does not exist, the Company recognizes the initial license
        fee as product revenues ratably over the initial term of the support agreement
        once support is the only undelivered element. The support period is generally
        12
        months but may be up to 18 months for initial orders because support begins
        when
        the licenses are downloaded, when support commences, or no more than six
        months
        following the contract date. The Company determines VSOE of support in perpetual
        agreements based on substantive renewal rates the customer must pay to renew
        the
        support. The VSOE of other services is based on amounts charged when the
        services are sold in stand-alone sales.
 
 For
        an
        annually renewable license agreement, which includes bundled support, upon
        meeting the revenue recognition criteria above, the Company recognizes 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.
 
 The
        Company recognizes revenues related to any hardware sales when the hardware
        is
        delivered and all other criteria are met.
 
 *Services
        Revenues*
 
 Services
        revenues are primarily recognized for renewal fees and support related to
        annually renewable license agreements and support fees for perpetual license
        agreements. For annually renewable agreements, the allocation of the initial
        order between product revenues and services revenues is based on the average
        renewal rates of all time based contracts. The Company applies the allocation
        of
        product revenues and services revenues consistently to all annually renewable
        agreements. Under annually renewable license agreements, after the initial
        license period, the Company’s customers may renew their license agreement for an
        additional period, typically 12 months, by paying a renewal fee. The revenue
        for
        the annual renewal fees are all classified under services revenue and the
        revenue is recognized ratably over the contract period. Under perpetual license
        agreements, the Company recognizes annual support fees as services revenues
        ratably over the post-contract support period, which is typically 12
        months.
 
 The
        Company also generates revenues from other services that it provides to its
        partners and customers. These additional revenues include fees for professional
        services and educational services. Revenues from professional services, which
        include implementing the Company’s products for a customer and educational
        services, which consist of training courses for partners and customers, are
        recognized as the related services are performed.
  *Stock-Based
        Compensation*
 
 The
          Company accounts for its employee and director stock options in accordance
          with
          Financial Accounting Standards Board (“FASB”) Statement of Financial Accounting
          Standards (“SFAS”) No. 123 (revised 2004), *Share-Based
          Payment* (“SFAS
          123R”) and the guidance of the SEC Staff Accounting Bulletin No. 107 (“SAB
          107”), which requires the measurement and recognition of compensation expense
          for all share-based payment awards made to employees and directors, based
          on
          fair values. As permitted by SFAS 123R, the Company used the Black-Scholes
          option-pricing model as its method of valuation for share-based payment
          awards.
          The Company’s determination of fair value of share-based payment awards on the
          date of grant using an option-pricing model is affected by the Company’s stock
          price as well as assumptions regarding a number of highly complex and subjective
          variables. These variables include, but are not limited to, the Company’s
          expected stock price volatility over the term of the awards and an expected
          risk-free rate of return. If factors change and the Company uses different
          assumptions for estimating stock-based compensation expense in future periods,
          stock-based compensation expense may differ materially in the future from
          that
          recorded in the current period.
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 **I**nteractiveIntelligence,
          Inc.****
 **Notes
          To Condensed Consolidated Financial Statements**
 **March
          31, 2007 and 2006 (unaudited)**
 Stock-based
            compensation expense for employee stock options recognized under SFAS
            123R for
            the three months ended March 31, 2007 and 2006 was $668,000 and $489,000,
            respectively.
 *Income
          Taxes*
 
 Income
        taxes are accounted for under the asset and liability method. Deferred tax
        assets and liabilities are recognized for the future tax consequences
        attributable to differences between the financial statement carrying amounts
        of
        existing assets and liabilities and their respective tax bases and operating
        loss and tax credit carry-forwards. Deferred tax assets and liabilities are
        measured using enacted tax rates expected to apply to taxable income in the
        years in which those temporary differences are expected to be recovered or
        settled. The effect on deferred tax assets and liabilities of a change in
        tax
        rates is recognized in income in the period that includes the enactment
        date.
 
 SFAS
        No.
        109, *Accounting
        for Income Taxes* (“SFAS
        109”), establishes financial accounting and reporting standards for the effect
        of income taxes. The Company is subject to income taxes in both the United
        States and numerous foreign jurisdictions. Significant judgment is required
        in
        evaluating the Company’s tax positions and determining its provision for income
        taxes. The objectives of accounting for income taxes are to recognize the
        amount
        of taxes payable or refundable for the current year and deferred tax liabilities
        and assets for the future tax consequences of events that have been recognized
        in an entity’s financial statements or tax returns. Variations in the actual
        outcome of these future tax consequences could materially impact the Company’s
        financial position, results of operations, or cash flows.
 
 In
        assessing the recoverability of deferred tax assets, management considers
        whether it is more likely than not that some portion or all of the deferred
        tax
        assets will not be realized. The ultimate realization of deferred tax assets
        is
        dependent upon generation of future taxable income during the periods in
        which
        temporary differences become deductible. Management considers projected future
        taxable income and tax planning strategies in making this assessment and
        ensuring that the deferred tax asset valuation allowance is adjusted as
        appropriate.
  See
          Note
          7 for further information on the Company’s income taxes.
 
 *Legal
        Proceedings*
 
 Liabilities
        for loss contingencies arising from claims, assessments, litigation, fines,
        and
        penalties and other sources are recorded when it is probable that a liability
        has been incurred and the amount of the assessment and/or remediation can
        be
        reasonably estimated. Legal costs incurred in connection with loss contingencies
        are expensed as incurred.
 
 *Reclassifications*
 
 Certain
          reclassifications have been made to prior year amounts to conform to the
          current
          period presentation. Prior to January 1, 2007, costs related to the development
          of the Company’s packaged solutions were included in cost of services. Beginning
          January 1, 2007, these costs have been reclassified from cost of services
          to
          research and development.
 
 **3.**
              **NET
                  INCOME PER SHARE**
 
 Basic
        net
        income per share is calculated based on the weighted-average number of
        outstanding common shares in accordance with SFAS 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.
        When the Company reports net income, the calculation of diluted net income
        per
        share excludes shares underlying outstanding stock options that would be
        antidilutive. Potential common shares are composed of shares of common stock
        issuable upon the exercise of stock options (in thousands, except per share
        amounts).
 **Three
                  Months Ended March 31,****2007**
              
              **2006**Net
                  income, as reported (A)
              
              $
              1,668
              
              $
              1,012Weighted
                  average outstanding shares of common stock (B)
              
              
              17,247
              
              
              16,251Dilutive
                  effect of employee stock options
              
              
              1,989
              
              
              927Common
                  stock and common stock equivalents (C)
              
              
              19,236
              
              
              17,178Net
                  income per share:Basic
                  (A/B)
              
              $
              0.10
              
              $
              0.06Diluted
                  (A/C)
              
              
              0.09
              
              
              0.06
 
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 **Interactive****Intelligence,
        Inc.**
 **Notes
          To Condensed Consolidated Financial Statements**
 **March
          31, 2007 and 2006 (unaudited)**
  Antidilutive
          shares not included in the diluted per share calculation for the three
          months
          ended March 31, 2007 and 2006 were 412,293 and 1.3 million,
          respectively.
 **4.**
              **STOCK-BASED
                  COMPENSATION**
 
 The
        Company’s Stock Option Plans, adopted in 1995, 1999 and 2006, authorize the
        Board of Directors or the Compensation Committee, as applicable, to grant
        incentive and nonqualified stock options, and, in the case of the 2006 Equity
        Incentive Plan (the “2006 Plan”), stock appreciation rights, restricted stock,
        restricted stock units, performance shares, performance units and other
        stock-based awards. The 2006 Plan was adopted at the Company’s 2006 Annual
        Meeting of Shareholders held in May 2006. After adoption of the 2006 Plan,
        the
        Company may no longer issue grants from previous plans, but any shares subject
        to awards under the 1999 Stock Option and Incentive Plan and the Outside
        Directors Stock Option Plan (collectively, the “1999 Plans”) that are cancelled
        will be added to shares available under the 2006 Plan. A maximum of 4,950,933
        shares are available for delivery under the 2006 Plan, which consists of
        (i)
        1,250,000 shares, plus (ii) 320,000 shares available for issuance under the
        1999
        Plans, but not underlying any outstanding stock options or other awards under
        the 1999 Plans, plus (iii) up to 3,380,933 shares subject to outstanding
        stock
        options or other awards under the 1999 Plans that expire, are forfeited or
        otherwise terminate unexercised on or after May 18, 2006. The number of shares
        available under the 2006 Plan is subject to adjustment for certain changes
        in
        the Company’s capital structure. The exercise price of options granted under the
        2006 Plan is equal to the closing price of the Company’s common stock on the
        last trading day prior to the date of grant.
 
 Options
          granted under the 2006 Plan prior to 2007 generally vest in equal annual
          installments over four years from the first anniversary of the date of
          grant,
          although the vesting period for a grant is at the Compensation Committee’s
          discretion. Stock options granted in the three month period ended March
          31, 2007
          were categorized into two groups: executive officer grants and non-executive
          officer and director grants. Stock options granted to non-executive officers
          and
          directors during the period are subject only to normal service vesting.
          The fair
          value of these non-executive officer and director option grants is estimated
          on
          the date of grant and the related compensation expense is recognized for
          the
          entire award on a straight-line basis over the vesting period. Stock options
          granted to executive officers during the period are subject to cancellation
          if
          specified performance targets for fiscal 2007 (as defined in the executives’
          2007 compensation plans) are not achieved. If the applicable performance
          targets
          are achieved, the options will vest in four equal installments on each
          of
          January 1, 2009, 2010, 2011 and 2012. The fair value of the executive officer
          option grants is estimated on the date of grant and the related compensation
          expense is recognized over the requisite service period, including the
          initial
          period for which the performance targets must be met, for each separately
          vesting portion of the award as if each vesting tranche was a separate
          award.
          The valuation assumptions used for each method are similar, although tailored
          for each vesting tranche of the awards for the executive officer
          grants.
 
 For
        most
        options granted through December 31, 2004, the term of each option is ten
        years
        from the date of grant. In 2005, the Company began issuing options with a
        term
        of six years from the date of grant.
 
 If
        an
        option is granted to an employee who, at the time the option is granted,
        owns
        stock representing more than ten percent of the voting power of all classes
        of
        stock of the Company, the exercise price of the option may not be less than
        110%
        of the market value per share on the date the option is granted and the term
        of
        the option shall be not more than five years from the date of
        grant.
 
 The
        plans
        may be terminated by the Board of Directors at any time.
 
 *Expense
        Information under SFAS 123R*
 
 The
        following table summarizes the allocation of stock-based compensation expense
        related to employee stock options under SFAS 123R for the three months ended
        March 31, 2007 and 2006 (in thousands, except per share amounts):
 
 **Three
                  Months Ended March 31,****2007**
              
              **2006**Stock-based
                  compensation expense for employee stock options by
                  category:Cost
                  of services
              
              $
              46
              
              $
              39Sales
                  and marketing
              
              
              300
              
              
              285Research
                  and development
              
              
              100
              
              
              49General
                  and administrative
              
              
              222
              
              
              116Total
                  stock-based compensation expense for employee stock
                  options
              
              $
              668
              
              $
              489Effect
                  of stock-based compensation for employee stock options on net income
                  per
                  shareBasic
              
              $
              (0.04
              )
              $
              (0.03
              )Diluted
              
              
              (0.03
              )
              
              (0.03
              )
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 **Interactive****Intelligence,
          Inc.**
 **Notes
          To Condensed Consolidated Financial Statements**
 **March
          31, 2007 and 2006 (unaudited)**
 **5.**
              **CONCENTRATION
                  OF CREDIT RISK**
 
 No
        partner represented a greater than 10% concentration of the Company’s accounts
        receivable as of March 31, 2007. One partner had a concentration of 12% of
        the
        Company’s accounts receivable as of March 31, 2006. No customer or partner
        accounted for 10% or more of the Company’s accounts receivable at December 31,
        2006. In addition, no customers or partners had greater than 10% concentration
        of the Company’s revenues for the three months ended March 31, 2007 and
        2006.
 
 **6.**
              **COMMITMENTS
                  AND CONTIGENCIES**
 
 *Legal
        Proceedings*
 
 From
        time
        to time, the Company has received notification from competitors and other
        technology providers claiming that the Company’s technology infringes their
        proprietary rights. 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.
 
 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. In December 2005, the Company received an additional
          notification from the French government as a result of an updated tax audit
          that
          they conducted. Both of 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 March 31, 2007, the assessment
          related
          to VAT was approximately $5.7 million. The Company’s tax counsel has assessed
          the possibility of the Company paying the assessment related to VAT as
          remote
          and therefore, the Company has not accrued the VAT amount. The Company
          has filed
          for VAT refunds in France of more than $600,000, which the Company has
          not
          recorded as a receivable and to which the French government has not yet
          responded. The Company believes that these VAT refunds could be used to
          offset
          amounts owed to the French government in connection with the assessments.
          As of
          March 31, 2007, the assessment related to corporation taxes was approximately
          $681,000. The Company’s tax counsel has assessed the possibility of the Company
          paying the assessment related to corporation taxes as reasonably possible.
          As of
          March 31, 2007, the Company has recorded what it deems an appropriate amount
          for
          corporation taxes. The Company is appealing both the VAT and corporation
          tax
          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.
 
 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.
  *Other
          Contingencies*
 The
        Company has received and may continue to receive certain payroll tax credits
        and
        real estate tax abatements that were granted to the Company based upon certain
        growth projections.  If the Company’s actual results are less than those
        projections, the Company may be subject to repayment of some or all
        of the
        payroll taxes or payment of additional real estate taxes in the case of the
        abatements.  The Company does not believe that it will be subject
        to
        payment of any money related to these taxes, however the Company cannot provide
        assurance as to the outcome.
 
 **7.**
              **INCOME
                  TAXES**
 
 The
        Company recorded its income taxes in accordance with SFAS 109. Management
        considers, when assessing the realizability of deferred tax assets, whether
        it
        is more likely than not that some portion or all of the deferred tax assets
        will
        not be realized. The ultimate realization of deferred tax assets is dependent
        upon the generation of future taxable income during the periods in which
        those
        temporary differences become deductible. Management considers the scheduled
        reversal of deferred tax liabilities, if any, projected future taxable income,
        and tax planning strategies in making this assessment.
 
 The
          Company had $44.1 million of tax net operating loss carry-forwards and
          $4.7
          million in tax credit carry-forwards at December 31, 2006. Included in
          the net
          operating loss carry-forwards was $8.7 million related to disqualifying
          dispositions of stock options. The tax benefit of these deductions, if
          realized
          for financial reporting purposes, will be recorded as a credit to additional
          paid-in capital. The Company recorded an income tax benefit of $5.0 million
          during the third quarter of 2006 to reduce the valuation allowance for
          its
          deferred tax assets. Management will continue to evaluate the recoverability
          of
          the deferred tax assets on a quarterly basis.
  Effective
          January 1, 2007, the Company adopted FIN
          48.
          FIN 48 prescribes a recognition threshold and measurement attributes for
          the
          financial statement recognition and measurement of a tax position taken
          or
          expected to be taken in a tax return. Adoption of FIN 48 had no impact
          on the
          Company's consolidated results of operations and financial
          position.
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 **Interactive****Intelligence,
          Inc.**
 **Notes
          To Condensed Consolidated Financial Statements**
 **March
          31, 2007 and 2006 (unaudited)**
  Upon
            adoption of FIN 48, the Company identified an uncertain tax position
            related to
            certain tax credits that the Company currently believes may not meet
            the more
            likely than not recognition threshold under FIN 48 to be sustained upon
            examination. Since this uncertain tax position has not been utilized
            and had a
            full valuation allowance established, the effect would be to reduce the
            gross
            deferred tax asset and valuation allowance by $4.7 million. This amount
            relates
            to unrecognized tax benefits that would impact the effective tax rate
            if
            recognized absent the valuation allowance. The Company and its subsidiaries
            file
            income tax returns in the U.S. federal jurisdiction, and various states
            and
            foreign jurisdictions. Tax years 2003 and forward remain open for examination
            for federal tax purposes and tax years 2002 and forward remain open for
            examination for the Company’s more significant state tax jurisdictions. To the
            extent utilized in future years’ tax returns, net operating loss and capital
            loss carry forwards at March 31, 2007 will remain subject to examination
            until
            the respective tax year is closed.
 **8.**
              **RECENT
                  ACCOUNTING PRONOUNCEMENTS**
 
 In
        February 2007, the FASB issued SFAS No. 159, *The
        Fair Value Option for Financial Assets and Financial Liabilities - Including
        an
        amendment of SFAS No. 115* , *Accounting
        for Certain Investments in Debt and Equity Securities* (“SFAS
        159”). SFAS 159 permits entities to choose to measure many financial assets and
        financial liabilities at fair value. Unrealized gains and losses on items
        for
        which the fair value option has been elected are reported in earnings. SFAS
        159
        is effective for the fiscal year beginning January 1, 2008. The Company is
        currently evaluating the impact, if any, of the adoption of SFAS 159. The
        Company does not expect the adoption of SFAS 159 will have a material impact
        on
        its consolidated financial position, results of operations or cash
        flows.
 
 In
        September 2006, the FASB issued SFAS No. 157, *Fair
        Value Measurements* (“SFAS
        157”). SFAS 157 defines fair value, establishes a framework for measuring fair
        value in generally accepted accounting principles and expands disclosures
        about
        fair value measurements. This Statement applies to previous accounting
        pronouncements that require or permit fair value measurements. Accordingly,
        this
        Statement does not require any new fair value measurements. SFAS 157 is
        effective for the fiscal year beginning January 1, 2008. The Company is
        currently evaluating the impact, if any, of the adoption of SFAS 157. The
        Company does not expect the adoption of SFAS 157 will have a material impact
        on
        its consolidated financial position, results of operations or cash
        flows.
   **9.**
              **SUBSEQUENT
                  EVENT**
 
 On
        April
        23, 2007, the Company announced it had acquired the professional services
        division of Alliance Systems Ltd. for $1.1 million in cash, with adjustments
        for
        certain costs and pro-rated customer receipts, pursuant to an Asset Purchase
        Agreement, dated as of April 17, 2007. The Company funded the purchase price
        with cash available from operations.
  **Item
                  2****.**
              **Management’s
                  Discussion and Analysis of Financial Condition and Results of
                  Operations.**
 
 The
        following Management’s Discussion and Analysis of Financial Condition and
        Results of Operations is intended to provide investors with an understanding
        of
        the Company’s past performance, its financial condition and its prospects and
        should be read in conjunction with other sections of this Form 10-Q. Investors
        should carefully review the information contained in this report under Part
        II,
“Item 1A: Risk Factors”. The following will be discussed and
        analyzed:
  ·  Forward-Looking
        Information
 
 ·  Overview
        Business Strategy
 
 ·  Financial
        Highlights
 
 ·  Historical
        Results of Operations
 
 ·  Liquidity
        and Capital Resources
 
 ·  Critical
        Accounting Policies and Estimates
 
 **Forward-Looking
        Information**
 
 Certain
        statements in this Quarterly Report on Form 10-Q contain “forward-looking”
        information (as defined in the Private Securities Litigation Reform Act of
        1995,  Section
        27A of the Securities Act of 1933, as amended and Section 21E of the Securities
        Exchange Act of 1934, as amended) that involves risks and uncertainties which
        may cause actual results to differ materially from those predicted in the
        forward-looking statements. Forward-looking statements can often be identified
        by their use of such verbs as “expects”, “anticipates”, “believes”, “intend”,
“plan”, “may”, “should”, “will”, “would”, “will be”, “will continue”, “will
        likely result”, or similar verbs or conjugations of such verbs. If any of our
        assumptions on which the statements are based prove incorrect or should
        unanticipated circumstances arise, our actual results could materially differ
        from those anticipated by such forward-looking statements. The differences
        could
        be caused by a number of factors or combination of factors, including, but
        not
        limited to, rapid technological changes in the industry; our ability to maintain
        profitability, to manage successfully our growth and increasingly complex
        third
        party relationships, to maintain successful relationships with our current
        and
        any new resellers, to maintain and improve our current products and to develop
        new products and to protect our proprietary rights adequately; and other
        factors
        set forth in our Securities and Exchange Commission (“SEC”) filings, including
        the Item 1A “Risk Factors” section of our Annual Report on Form 10-K for the
        fiscal year ended December 31, 2006.
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 **Overview**
 
 Interactive
          Intelligence, Inc. (“Interactive Intelligence”, “we”, “us” or “our”) was formed
          in 1994 as an Indiana corporation and maintains its world headquarters
          and
          executive offices at 7601 Interactive Way, Indianapolis, IN 46278. Our
          telephone
          number is (317) 872-3000. We are located on the Web at *http://www.inin.com* .
          Our
          periodic and current reports and all amendments to those reports required
          to be
          filed or furnished pursuant to Section 13(a) or 15(d) of the Securities
          Exchange
          Act of 1934 are available free of charge through our investor relations
          page
          located on our Website at *http://www.inin.com* */investors* .
 We
        are a
        leading provider of software applications for contact centers and we are
        leveraging that leadership position to provide mission critical voice over
        Internet protocol (“VoIP”) applications to enterprises. Our solutions are
        utilized in contact centers of teleservices firms, international corporations,
        public agencies, telecommunications companies, distributed organizations,
        government and commercial enterprises, and increasingly for the remote and
        mobile workforce. We also offer the only pre-integrated all-software Internet
        Protocol Private Branch Exchange (“IP PBX”), a phone and communications solution
        for mid-sized enterprises that relies on the Microsoft Corporation (“Microsoft”)
        platform. We offer innovative software products and services for multi-channel
        contact management, business communications, messaging and session initiation
        protocol (“SIP”)-supported VoIP.
 
 Our
        application-based solutions are integrated on a platform that scales to
        thousands of users, and are developed to satisfy today’s diverse interaction
        needs in markets for:
 
 ·
              Contact
                  Centers
 
 ·
              Enterprise
                  IP Telephony
 
 ·
              Enterprise
                  Messaging
  ·
              Self-Service
                  Automation
 
 By
        implementing our all-in-one solutions, businesses are able to unify
        communications, enhance workforce effectiveness and productivity, and readily
        adapt to constantly changing market and customer requirements. Moreover,
        organizations are able to reduce the cost and complexity of traditional
“multi-point” legacy communications hardware systems that are seldom fully
        integrated.
 
 **Financial
        Highlights**
  For
        the
        three months ended March 31, 2007, revenues grew 1% over the previous three
        month period and 35% over the three months ended March 31, 2006. Factors
        that affect revenues in any particular quarter include potential customers’
        budget constraints, personnel resources to implement our solutions, historical
        product order patterns and willingness to implement a critical
        telecommunications system. As the table below shows, revenues in any particular
        quarter can greatly fluctuate from other periods. 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 when an
        order
        is received.
 
 The
        information below shows our total revenues (in millions) for the most recent
        five quarters and the years ended December 31, 2006, 2005 and 2004
        and the
        percentage change over the previous period.
 
 **Period**
              
              **Revenues**
              
              **%
                  Growth**Three
                  months ended:March
                  31, 2007
              
              $
              24.2
              
              
              1
              %December
                  31, 2006
              
              
              23.9
              
              
              8September
                  30, 2006
              
              
              22.2
              
              
              15June
                  30, 2006
              
              
              19.3
              
              
              8March
                  31, 2006
              
              
              17.9
              
              
              2Year
                  ended December 31:2006
              
              $
              83.2
              
              
              32
              %2005
              
              
              62.9
              
              
              142004
              
              
              55.1
              
              
              7
 
 Although
        revenues can fluctuate from quarter to quarter, we have experienced increasing
        annual revenue growth, which we attribute to a number of factors including
        but
        not limited to: adoption of VoIP technologies by our customers; increasing
        market awareness of our solutions; product improvements in scalability and
        the
        reliability of our products; reductions in hardware costs to deploy our
        solutions making our solutions more financially attractive to customers;
        changes
        in our sales program to target new customers; and establishment of an inside
        sales group to work with current customers.
 
 For
          the
          three months ended March 31, 2007, product revenues increased $3.4 million
          or
          38%, compared to the three months ended March 31, 2006. This increase was
          related to the incremental dollar value of orders received.
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 For
              the
              three months ended March 31, 2007, services revenues increased $2.9
              million or
              32%, compared to the same period in 2006. This increase was primarily
              related to
              additional support fees and annually renewable license fees, which
              were
              recognized for our growing installed customer base, and which were
              approximately
              75% of our first quarter 2007 services revenues. In addition, other
              services
              revenues, mainly professional services, increased $1.1 million, during
              the first
              quarter of 2007 compared to the same period in 2006, as our professional
              services group installed our solutions at some of our other large,
              direct
              customers that began licensing our solutions after the first quarter
              of 2006.
  Total
              cost of revenues increased 65% for the three months ended March 31,
              2007
              compared to the same period in 2006. This increase was primarily due
              to
              personnel-related costs in the services department and royalty expenses
              as a
              result of licensing more third party software as part of the orders
              received. In
              addition, in the three months ended March 31, 2007, we incurred hardware
              costs
              for handsets, servers, and gateways related to our IP PBX product,
              which were
              costs that were not incurred in the same period in
              2006.
 
 The
        following table summarizes stock-based compensation expense related to employee
        stock options under SFAS 123R for the three months ended March 31, 2007 and
        2006
        which was allocated as follows (in thousands, except per share
        amounts):
 
 **Three
                  Months Ended March 31,****2007**
              
              **2006**Stock-based
                  compensation expense for employee stock options by
                  category:Cost
                  of services
              
              $
              46
              
              $
              39Sales
                  and marketing
              
              
              300
              
              
              285Research
                  and development
              
              
              100
              
              
              49General
                  and administrative
              
              
              222
              
              
              116Total
                  stock-based compensation expense for employee stock
                  options
              
              $
              668
              
              $
              489Effect
                  of stock-based compensation for employee stock options on net income
                  per
                  shareBasic
              
              $
              (0.04
              )
              $
              (0.03
              )Diluted
              
              
              (0.03
              )
              
              (0.03
              )
 
 Prior
                  to
                  2007, our Compensation Committee granted stock options to our executive
                  officers
                  based on historical performance after our quarterly and/or annual
                  financial
                  results were known. For fiscal 2007, our Compensation Committee
                  granted stock
                  options to our executive officers at the beginning of the year
                  subject to
                  cancellation if specified performance targets for fiscal 2007 (as
                  defined in the
                  executives’ 2007 compensation plans) are not achieved (the “2007 options”). If
                  the applicable performance targets are achieved, the 2007 options
                  will vest in
                  four equal installments on each of January 1, 2009, 2010, 2011
                  and 2012. These
                  2007 options were granted at an exercise price of $17.28 per share,
                  the closing
                  price of our common stock, as reported by The NASDAQ Stock Market,
                  on February
                  14, 2007, the business day immediately preceding the grant date.
                  These 2007
                  options will expire on January 1, 2014, unless cancelled due to
                  failure to
                  achieve applicable performance targets or unless earlier terminated
                  in
                  accordance with the terms of our 2006 Plan. Our Compensation Committee
                  believes
                  that this practice will better reward our executive officers for
                  superior
                  performance. The fair value of these executive officer option grants
                  was
                  estimated on the date of grant and the related compensation expense
                  will be
                  recognized over the requisite service period, including the initial
                  period for
                  which the performance targets must be met, for each separately
                  vesting portion
                  of the award as if each vesting tranche was a separate award. The
                  fair value of
                  our remaining option grants is estimated on the date of grant and
                  the related
                  compensation expense of the entire award was recognized on a straight-line
                  basis
                  over the vesting period. Therefore, the increase in stock-based
                  compensation
                  expense from the first quarter of 2006 to the first quarter of
                  2007 was
                  primarily attributed to these 2007 options that have accelerated
                  compensation
                  expense recognition and were granted at the beginning of the year
                  instead of
                  after our quarterly and/or annual financial results are
                  determined.
 Based
        on
        currently issued non-vested options as of March 31, 2007, we expect expenses
        related to SFAS 123R to be approximately $2.2 million for the remainder of
        2007.
 
 Operating
                      expenses for the three months ended March 31, 2007 increased
                      $3.1 million or 24%
                      compared to the same period in 2006. Of this increase, we recognized
                      $179,000 of additional compensation expense related
                      to SFAS 123R, as
                      described above. In addition, we incurred additional compensation
                      expense of
                      $2.3 million due to a 24% increase in company-wide staffing.
                      We also incurred
                      other higher costs for professional services related to legal
                      and accounting
                      fees and outsourcing contractors. Sales and marketing expenses
                      during the first
                      quarter of 2007, as compared to 2006, included a $175,000 lump
                      sum severance
                      payment we made to a former executive officer. These increases
                      were slightly
                      offset by decreases in bad debt expense, marketing activities
                      and other
                      miscellaneous expenses.
  We
        had
        $31.5 million of cash and cash equivalents and short-term investments as
        of
        March 31, 2007 compared to $27.1 million as of December 31, 2006. This increase
        was primarily a result of net earnings for the three months ended
        March 31,
        2007, cash collections of accounts receivable and an increase in deferred
        services revenue. We continue to be debt free.
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  **Historical
        Results of Operations**
  The
        following table presents certain financial data, derived from our unaudited
        statements of income, as a percentage of total revenues for the periods
        indicated. The operating results for the three months ended March 31, 2007
        and
        2006 are not necessarily indicative of the results that may be expected for
        the
        full year or for any future period.
 
 **Three
                  Months Ended**
                **March
                  31,****2007**
              
              **2006**Revenues:Product
              
              
              51
              %
              
              49
              %Services
              
              
              49
              
              
              51Total
                  revenues
              
              
              100
              
              
              100Cost
                  of revenues:Product
              
              
              10
              
              
              8Services
              
              
              20
              
              
              17Total
                  cost of revenues
              
              
              30
              
              
              25Gross
                  profit
              
              
              70
              
              
              75Operating
                  expenses:Sales
                  and marketing
              
              
              36
              
              
              38Research
                  and development
              
              
              16
              
              
              17General
                  and administrative
              
              
              13
              
              
              14Total
                  operating expenses
              
              
              65
              
              
              69Operating
                  income
              
              
              5
              
              
              6Other
                  income (expense):Interest
                  income, net
              
              
              2
              
              
              --Other
                  expense, net
              
              
              --
              
              
              --Total
                  other income, net
              
              
              2
              
              
              --Income
                  before income taxes
              
              
              7
              
              
              --Income
                  tax expense
              
              
              --
              
              
              --Net
                  income
              
              
              7
              %
              
              6
              %
 
 **Comparison
        of Three Months Ended March 31, 2007 and 2006**
  ***Revenues***
  *Product
        Revenues*
 **Three
                  Months Ended**
                **March
                  31,****2007**
              
              **2006****($
                  in thousands)**Product
                  revenues
              
              $
              12,261
              
              $
              8,861Change
                  from prior year
              
              
              38
              %
              
              12
              %Percentage
                  of total revenues
              
              
              51
              %
              
              49
              %
 
 Product
          revenues, which include software and hardware, can fluctuate from quarter
          to
          quarter depending on several factors including the mix of orders between
          perpetual licenses and annually renewable licenses. Perpetual orders
          during
          the first quarter of 2007 accounted for 82% of product orders compared
          to 72%
          during the same period in 2006. If other revenue recognition criteria are
          satisfied, we recognize license revenue upfront for perpetual licenses,
          and we
          recognize revenue for annually renewable licenses ratably over the term.
          The
          impact of the mix of contracts on our product revenues occurs only in the
          initial year of an order; subsequent renewal fees received for the annually
          renewable licenses and the renewal support fees for perpetual contracts
          are all
          allocated entirely to services revenues.
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 The
            increase during the first quarter of 2007 compared to the same period
            in 2006
            was due primarily to a higher dollar amount of orders that we received.
            Orders
            received from existing customers increased 133% from the first quarter
            of 2006
            to the first quarter of 2007. The amount of orders we receive, while
            impacting
            products revenues, does not have an exact correlation to revenues because
            the
            terms in the contracts will determine whether we can recognize the order
            during
            the quarter or in subsequent quarters. So while the increase in orders
            did
            result in an increase in recognized product revenues, the increase in
            product
            revenues is also due to orders that were received in previous quarters
            that are
            being recognized in the current quarter.
  *Services
        Revenues*
 **Three
                  Months Ended**
                **March
                  31,****2007**
              
              **2006****($
                  in thousands)**Services
                  revenues
              
              $
              11,932
              
              $
              9,069Change
                  from prior year
              
              
              32
              %
              
              35
              %Percentage
                  of total revenues
              
              
              49
              %
              
              51
              %
 
 Services
        revenues include the portion of the initial license arrangement allocated
        to
        services revenues from annually renewable and perpetual contracts, license
        renewals of annually renewable contracts, and support fees for perpetual
        contracts, as well as professional services, education and other miscellaneous
        revenues.
 
 The
              increase during the first quarter of 2007 compared to the same period
              in 2006
              was due to our growing installed base of customers and related payments
              of
              annual license renewal fees and support fees for perpetual licenses.
              License
              renewal and support revenues generated incremental revenues of $1.4
              million
              during the first quarter of 2007 compared to the same period in 2006.
              As new
              customers license our solutions, we expect that our services revenues
              will
              increase as these customers continue to renew their licenses
              and pay for
              support on our solutions. The actual percentage fee charged for renewal
              of
              annually renewable licenses and perpetual support agreements as compared
              to the
              initial annually renewable license fee and perpetual license, respectively,
              is
              comparable on a relative percentage basis, and therefore, the mix of
              these types
              of contracts in the future is not expected to impact our future services
              revenues.
 
 Professional,
                educational and other services are included in services revenues
                and were $3.0
                million and $1.5 million for the three months ended March 31, 2007
                and 2006,
                respectively. These revenues have and will fluctuate based on the
                number of
                customers and partners that attend our educational classes, the amount
                of
                assistance our customers and partners need for implementation and
                installation
                and commissions that we receive on hardware sold to our end customers
                by a third
                party. Revenues from professional services increased $1.1 million
                from the first
                quarter of 2006 to the first quarter of 2007 due to more of our larger,
                direct
                customers utilizing our professional services group to assist in
                installing our
                solutions. We anticipate these revenues will continue to increase
                in 2007 if the
                number of our large, direct customers continues to grow. We also
                expect our
                April 2007 acquisition of the professional services division of Alliance
                Systems
                and their contracts will generate additional services revenues for
                us in the
                future.
 
 ***Cost
        of Revenues***
 **Three
                  Months Ended**
                **March
                  31,****2007**
              
              **2006****($
                  in thousands)**Cost
                  of revenues:Product
              
              $
              2,441
              
              $
              1,333Services
              
              
              4,797
              
              
              3,063Total
                  cost of revenues
              
              $
              7,238
              
              $
              4,396Change
                  from prior year
              
              
              65
              %
              
              27
              %Product
                  costs as a % of product revenues
              
              
              20
              %
              
              15
              %Services
                  costs as a % of services revenues
              
              
              40
              %
              
              34
              %
 
 Costs
        of
        product consist of product and software royalties paid to third parties for
        the
        use of their technologies in our products, hardware costs primarily associated
        with our IP PBX sales, costs for third-party royalties for software that
        we
        distribute 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 software, if any, which is licensed by the end user from us as
        part
        of our software applications and the dollar amount of IP PBX systems licensed
        that include hardware such as servers, telephone handsets, networking equipment
        and other hardware.
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 Costs
            of
            product increased during the first quarter of 2007 compared to the same
            period
            in 2006 primarily due to $628,000 related to royalties paid to third
            parties as
            we licensed more of their software as part of orders received and $373,000
            related to additional cost of hardware. In addition, we also increased
            staffing
            in our distribution center during the first quarter of 2007 compared
            to the same
            period in 2006 which resulted in a $72,000 increase in total
            compensation.
  Costs
              of
              services consist primarily of compensation expenses for technical support,
              educational and professional services personnel and other costs associated
              with
              supporting our partners and customers. These expenses increased during
              the first
              quarter of 2007, as compared to the same period in 2006, primarily
              due to a $1.1
              million increase in compensation expense as a result of a 40% increase
              in our
              services staffing. In addition, we also experienced more demand for
              our
              professional services personnel to install our solutions at our customers’
              sites. This resulted in additional costs of $384,000 related to contracting
              outsourced professionals and $77,000 for travel-related expenses. The
              remaining
              increase was due to higher communication costs, more software purchases
              and
              depreciation expense. We anticipate these costs will continue to increase
              in
              2007 if the number of our large, direct customers continues to grow.
              We also
              expect our April 2007 acquisition of the professional services division
              of
              Alliance Systems and their contracts will generate additional services
              costs for
              us in the future.
 ***Gross
        Profit***
 **Three
                  Months Ended**
                **March
                  31,****2007**
              
              **2006****($
                  in thousands)**Gross
                  profit
              
              $
              16,955
              
              $
              13,534Change
                  from prior year
              
              
              25
              %
              
              21
              %Percentage
                  of total revenues
              
              
              70
              %
              
              75
              %
 
 Gross
        profit as a percentage of total revenues decreased during the three months
        ended
        March 31, 2007 compared to the same period in 2006, primarily due to additional
        hardware costs and royalties incurred during the first quarter of 2007. The
        gross margin on our hardware sales is less than the gross margin on our software
        licenses; therefore, as we continue to sell more hardware with our software
        orders, our total gross margin may decrease compared to historical margins.
        Gross margin in any particular quarter is dependent upon our product mix
        related
        to recognized orders and is expected to vary.
  ***Operating
        Expenses***
  *Sales
        and Marketing*
 **Three
                  Months Ended**
                **March
                  31,****2006**
              
              **2005****($
                  in thousands)**Sales
                  and marketing expenses
              
              $
              8,644
              
              $
              6,879Change
                  from prior year
              
              
              26
              %
              
              18
              %Percentage
                  of total revenues
              
              
              36
              %
              
              38
              %Percentage
                  of net product revenues
              
              
              88
              %
              
              91
              %
 Sales
          and
          marketing expenses are comprised primarily of compensation expenses, travel
          and
          entertainment expenses and promotional costs related to our sales, marketing,
          and channel management operations. These expenses increased during the
          first
          quarter of 2007, as compared to the same period in 2006, primarily due
          to $1.4
          million of additional compensation expense, which resulted from a 25% increase
          in our sales and marketing staffing. The increase also included a $175,000
          lump
          sum severance payment we made to a former executive officer. We also incurred
          additional costs of $193,000 and $87,000 related to travel and recruiting
          expenses, respectively.
  Sales
          and marketing
          expenses as a percentage of total revenues and as a percentage of net product
          revenues decreased during the three months ended March 31, 2007 as compared
          to
          the same period in 2006. These decreases reflect efficiencies that we are
          realizing in these areas as our revenues continue to
          increase.
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 *Research
        and Development*
 **Three
                  Months Ended**
                **March
                  31,****2007**
              
              **2006****($
                  in thousands)**Research
                  and development expenses
              
              $
              3,897
              
              $
              3,122Change
                  from prior year
              
              
              25
              %
              
              (2
              )%Percentage
                  of total revenues
              
              
              16
              %
              
              17
              %
  Research
            and
            development expenses are comprised primarily of compensation and depreciation
            expenses. During the first quarter of 2007, as compared to the same period
            in
            2006, compensation expenses increased by $558,000 as a result of a 23%
            increase
            in our research and development staffing.
 *General
        and Administrative*
 **Three
                  Months Ended**
                **March
                  31,****2007**
              
              **2006****($
                  in thousands)**General
                  and administrative expenses
              
              $
              3,065
              
              $
              2,534Change
                  from prior year
              
              
              21
              %
              
              25
              %Percentage
                  of total revenues
              
              
              13
              %
              
              14
              %
  General
                              and
                              administrative expenses are comprised of compensation
                              expense and general
                              corporate expenses that are not allocable to other
                              departments including legal
                              and other professional fees and bad debt expense. General
                              and administrative
                              expenses increased during the first quarter of 2007,
                              as compared to the same
                              period in 2006, primarily due to $344,000 of additional
                              compensation expense,
                              which resulted from a 23% increase in our general and
                              administrative staffing.
                              Included in the compensation increase was $106,000
                              of additional SFAS 123R
                              expense, which was a result of the 2007 options granted
                              during the first quarter
                              of 2007. In 2007, we changed our executive officers’ compensation plans and
                              granted them performance-based stock options subject
                              to cancellation if
                              specified performance targets for fiscal 2007 (as defined
                              in the executives’
                              2007 compensation plans) are not achieved. These 2007
                              options were granted at
                              the beginning of the year compared to granting the
                              options after our quarterly
                              and/or annual financial results are determined. Because
                              of this change, we
                              recognized more compensation expense in the first quarter
                              of 2007 for these 2007
                              options. The remaining increase was due to miscellaneous
                              costs such as
                              outsourced services and meals and
                              entertainment.
 ***Other
        Income (Expense)***
  *Interest
        Income, Net*
 **Three
                  Months Ended March 31,****2007**
              
              **2006****($
                  in thousands)**Cash,
                  cash equivalents and short-term investments (average)
              
              $
              29,300
              
              $
              16,998Interest
                  income
              
              
              472
              
              
              107Return
                  on investment (annualized)
              
              
              6.4
              %
              
              2.5
              %
 
 Interest
          income, net is primarily comprised of interest earned from investments
          and
          interest-bearing cash accounts. Interest expense and fees, which are not
          material for any periods reported, are also included in interest income,
          net.
          Interest earnings improved during the three months ended March 31, 2007
          compared
          to the same period in 2006 as shown above. Interest earned on investments
          improved partially due to increasing cash and investment balances. In addition,
          we reallocated the funds in which we have invested to increase our return
          on
          investment. These new investments have higher interest rates and lower
          fees.
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  *Other
        Expense, Net*
 **Three
                  Months Ended March 31,****2007**
              
              **2006****($
                  in thousands)**Other
                  expense, net
              
              $
              (56
              )
              $
              (52
              )
 
 Other
        expense, net includes foreign currency transaction gains and losses, as well
        as
        foreign tax withholdings. These amounts depend on the amount of revenue that
        is
        generated in certain international currencies, particularly the Euro, and
        the
        exchange gain or loss that results from foreign currency disbursements and
        receipts. The increase in the expense during the three months ended March
        31,
        2007 was primarily due to additional foreign tax withholdings compared
        to
        the same period in 2006.
  **Liquidity
        and Capital Resources**
  We
        generate cash from the collections we receive related to licensing our contact
        center and IP-PBX applications and from annual license renewals, maintenance
        and
        support and other services revenues. We also have in place an unused $3.0
        million line of credit. We use cash primarily for paying our employees
        (including salaries, commissions and benefits), leasing office space, paying
        travel expenses, marketing activities, paying vendors for other services
        and
        supplies and purchasing property and equipment.
 
 We
        determine liquidity by combining cash and cash equivalents and short-term
        investments net of any outstanding borrowings on our line of credit as shown
        in
        the table below. Our total liquidity position as of March 31, 2007 improved
        compared with our position as of December 31, 2006 due mainly to increased
        net
        income, increasing deferred revenue balances and strong cash collections.
        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.
 
 **March
                  31,**
              
              **December
                  31,****2007**
              
              **2006****($
                  in thousands)**Cash
                  and cash equivalents
              
              $
              22,516
              
              $
              13,531Short-term
                  investments
              
              
              8,997
              
              
              13,555Liquidity,
                  net
              
              $
              31,513
              
              $
              27,086
 
 Our
        operating activities resulted in net cash provided of $4.9 million and $3.3
        million for the three months ended March 31, 2007 and 2006, respectively.
        This
        increase in net cash provided was primarily a result of increased net income
        and
        deferred services revenues and increased cash collections.
 
 The
        amount that we report as cash and cash equivalents or as temporary investments
        fluctuates depending on investing decisions 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.
  Net
        cash
        provided by investing activities was $3.4 million for the three months ended
        March 31, 2007 compared to net cash used in investing activities of $1.7
        million
        for the three months ended March 31, 2006. This increase in cash was primarily
        due to proceeds of $8.2 million received for available-for-sale investments
        that
        matured during the three months ended March 31, 2007 compared to no maturities
        during the same period in 2006. In contrast, we purchased $3.5 million and
        $1.2
        million of available-for-sale investments during the three months ended March
        31, 2007 and 2006, respectively. We also purchased property and equipment
        totaling $1.3 million and $488,000 during the three months ended March 31,
        2007
        and 2006, respectively. These purchases related mainly to hardware and leasehold
        improvements for our corporate headquarters and regional headquarters offices.
        As our property and equipment becomes obsolete and as our operations continue
        to
        grow, we anticipate that our purchases of property and equipment will continue
        to increase in future periods.
 
 Net
        cash
        provided by financing activities was $724,000 and $919,000 for the three
        months
        ended March 31, 2007 and 2006, respectively. The decrease in cash provided
        was
        mainly due to lower proceeds from stock options that were exercised during
        the
        three months ended March 31, 2007. As our stock price fluctuated during the
        three months ended March 31, 2007 from $22.42 per share as of December 31,
        2006
        down to $13.94 per share during the three months ended March 31, 2007, fewer
        stock options were exercised compared to the same period in 2006. Our stock
        price was $15.24 per share as of March 30, 2007 as reported by The NASDAQ
        Stock
        Market.
 
 On
          April
          23, 2007, we announced we had acquired the professional services division
          of
          Alliance Systems Ltd. for $1.1 million in cash, with adjustments for certain
          costs and pro-rated customer receipts, pursuant to an Asset Purchase Agreement,
          dated as of April 17, 2007. We funded the purchase price with cash available
          from operations. A total of 13 professional services engineers and one
          sales
          representative joined our company as a result of the acquisition. These
          individuals are experienced with our applications and their implementation.
          In
          addition, there were existing contracts and customer relationships that
          we
          acquired as part of the acquisition.
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 On
        October 19, 2006, we filed with the SEC a registration statement on Form
        S-3
        utilizing the “shelf” registration process. This registration statement has not
        yet been declared effective by the SEC but if and when effective, it will
        allow
        us to offer and sell up to 3,000,000 shares of our common stock from time
        to
        time in one or more transactions. In addition, under this shelf registration
        statement, Dr. Donald E. Brown, our Chairman of the Board, President and
        CEO,
        registered 1,000,000 shares of our common stock that he owns for sale from
        time
        to time. Although the shelf registration statement, if and when effective,
        will
        permit us to offer and sell up to 3,000,000 shares of our common stock, doing
        so
        remains at the discretion of the Board of Directors, and there is no assurance
        that we would be able to complete any such offering of our common stock.
  There
            have been no material changes in our contractual obligations described
            in our
            Annual Report on Form 10-K for the year ended December 31, 2006, except
            for the
            additional amounts listed below. The obligations listed below all relate
            to
            operating lease obligations for additional offices in China and Germany
            entered
            into during the first quarter of 2007 and are incremental to the operating
            lease
            obligations disclosed in our Annual Report on Form 10-K for the year
            ended
            December 31, 2006.
 **Payments
                    Due by Period****Total**
                
                **Less
                    than**
                  **1
                    Year**
                
                **1-3
                    Years**
                
                **3-5
                    Years**
                
                **More
                    than**
                  **5
                    Years****Contractual
                    Obligations**Operating
                    lease obligations
                
                $
                68,216
                
                $
                51,162
                
                $
                17,054
                
                
                --
                
                
                --
 **Critical
        Accounting Policies and Estimates**
  We
          believe the accounting policies listed below are important to understanding
          our
          historical and future performance, as these policies affect the reported
          amounts
          of revenues and income and are the more significant areas involving management’s
          judgments and estimates. These policies, and our procedures related to
          these
          policies, are described below. See also Note 2 of Notes to Consolidated
          Financial Statements included in our Annual Report on Form 10-K for the
          year
          ended December 31, 2006 for a further summary of our other significant
          accounting policies.
 
 ***Sources
        of Revenues and Revenue Recognition Policy***
  We
          generate product revenues from licensing the right to use our software
          applications and in certain instances providing hardware as a component
          of our
          solution, and we generate services revenues primarily from annual support
          fees,
          annual renewal fees, professional services and educational services.
 
 *Product
        Revenues*
 
 Our
        license agreements are either perpetual or annually renewable. For any revenues
        to be recognized from a 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
        a
        perpetual 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 of fair value
        (“VSOE”) exists to support allocating a portion of the total fee to the
        undelivered elements of the arrangement. If sufficient VSOE of the
        undelivered elements does not exist, we recognize the initial license fee
        as
        product revenues ratably over the initial term of the support agreement once
        support is the only undelivered element. The support period is generally
        12
        months but may be up to 18 months for initial orders because support begins
        when
        the licenses are downloaded, when support commences, or no more than six
        months
        following the contract date. We determine VSOE of support in perpetual
        agreements based on substantive renewal rates the customer must pay to renew
        the
        support. The VSOE of other services is based on amounts charged when the
        services are sold in stand-alone sales.
 
 For
        an
        annually renewable license agreement, which includes bundled support, 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.
 
 We
        recognize revenues related to any hardware sales when the hardware is delivered
        and all other criteria are met.
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 *Services
        Revenues*
 
 Services
        revenues are primarily recognized for renewal fees and support related to
        annually renewable license agreements and support fees for perpetual license
        agreements. For annually renewable agreements, the allocation of the initial
        order between product revenues and services revenues is based on the average
        renewal rates of all time based contracts. We apply the allocation of product
        revenues and services revenues consistently to all annually renewable
        agreements. Under annually renewable 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. The revenue
        for
        the annual renewal fees are all classified under services revenue and the
        revenue is recognized ratably over the contract period. Under perpetual license
        agreements, we recognize annual support fees as services revenues ratably
        over
        the post-contract support period, which is typically 12 months.
  We
        also
        generate revenues from other services that we provide to our partners and
        customers. These additional revenues include fees for professional services
        and
        educational services. Revenues from professional services, which include
        implementing our products for a customer, and educational services, which
        consist of training courses for partners and customers, are recognized as
        the
        related services are performed.
  ***Stock-Based
        Compensation Expense***
 
 We
          account for our employee and director stock options in accordance with
          SFAS 123R
          and the guidance of SAB 107, which requires the measurement and recognition
          of
          compensation expense for all share-based payment awards made to employees
          and
          directors, based on fair values. As permitted by SFAS 123R, we continued
          to use
          the Black-Scholes option-pricing model as our method of valuation for
          share-based payment awards. Our determination of fair value of share-based
          payment awards on the date of grant using an option-pricing model is affected
          by
          our stock price as well as assumptions regarding a number of highly complex
          and
          subjective variables. These variables include, but are not limited to,
          our
          expected stock price volatility over the term of the awards and an expected
          risk-free rate of return. If factors change and we use different assumptions
          for
          estimating stock-based compensation expense in future periods, stock-based
          compensation expense may differ materially in the future from that recorded
          in
          the current period.
 
 Stock-based
        compensation expense for employee stock options recognized under SFAS 123R
        for
        the three months ended March 31, 2007 and 2006 was $668,000 and $489,000,
        respectively.
 
 ***Income
        Taxes***
 
 Income
        taxes are accounted for under the asset and liability method. Deferred tax
        assets and liabilities are recognized for the future tax consequences
        attributable to differences between the financial statement carrying amounts
        of
        existing assets and liabilities and their respective tax bases and operating
        loss and tax credit carry-forwards. Deferred tax assets and liabilities are
        measured using enacted tax rates expected to apply to taxable income in the
        years in which those temporary differences are expected to be recovered or
        settled. The effect on deferred tax assets and liabilities of a change in
        tax
        rates is recognized in income in the period that includes the enactment
        date.
 
 SFAS
        No.
        109, *Accounting
        for Income Taxes* ,
        establishes financial accounting and reporting standards for the effect of
        income taxes. We are subject to income taxes in both the United States and
        numerous foreign jurisdictions. Significant judgment is required in evaluating
        our tax positions and determining our provision for income taxes. The objectives
        of accounting for income taxes are to recognize the amount of taxes payable
        or
        refundable for the current year and deferred tax liabilities and assets for
        the
        future tax consequences of events that have been recognized in an entity’s
        financial statements or tax returns. Variations in the actual outcome of
        these
        future tax consequences could materially impact our financial position, results
        of operations, or cash flows.
 
 In
        assessing the recoverability of deferred tax assets, management considers
        whether it is more likely than not that some portion or all of the deferred
        tax
        assets will not be realized. The ultimate realization of deferred tax assets
        is
        dependent upon generation of future taxable income during the periods in
        which
        temporary differences become deductible. Management considers projected future
        taxable income and tax planning strategies in making this assessment and
        ensuring that the deferred tax asset valuation allowance is adjusted as
        appropriate.
  See
          Note
          7 of Notes to Condensed Consolidated Financial Statements for further
          information on our income taxes.
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  ***Allowance
        for Doubtful Accounts Receivable***
 
 We
        record
        bad debt expense based on a percentage of revenue reported each period. We
        then
        review the allowance for doubtful accounts for each reporting period based
        on a
        detailed analysis of our accounts receivable to determine that the amount
        of the
        allowance for doubtful accounts receivable is appropriately stated at the
        end of
        that period. In the analysis of accounts receivable, we primarily consider
        the
        age of the partner’s or customer’s receivable and also consider the
        creditworthiness of the partner 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 partner 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 partner’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.
 
 ***Research
        and Development***
 
 Through
        March 31, 2007, 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.
 
 ***Legal
        Proceedings***
 
 Liabilities
        for loss contingencies arising from claims, assessments, litigation, fines,
        and
        penalties and other sources are recorded when it is probable that a liability
        has been incurred and the amount of the assessment and/or remediation can
        be
        reasonably estimated. Legal costs incurred in connection with loss contingencies
        are expensed as incurred.
  **Item
        3. Quantitative and Qualitative Disclosures about Market
        Risk.**
 
 We
        develop products in the United States and license our products in the Americas, Europe,
        the Middle East and Africa  and Asia/Pacific .
        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.
 
 **Ite****m
        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 (the “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 March 31, 2007 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 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 March 31, 2007 that have materially affected,
        or are reasonably likely to materially affect, our internal control over
        financial reporting.
  **P** **ART
        II. OTHER INFORMATION**
 
 **It****em
        1. Legal Proceedings.**
  The
        information set forth in Note 6 of Notes to Condensed Consolidated Financial
        Statements included in Part I, Item 1 of this report is incorporated herein
        by
        reference.
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  **Item****1A. Risk Factors.**
 
 In
        addition to the information set forth in this Report and before deciding
        to
        invest in, or retain, shares of our common stock, you also should carefully
        review and consider the information contained in our other reports and periodic
        filings that we make with the SEC, including, without limitation, the
        information contained under the caption “Item 1A. Risk Factors” in our Annual
        Report on Form 10-K for the year ended December 31, 2006. Those risk factors
        could materially affect our business, financial condition and results of
        operations.
 
 The
        risks
        that we describe in our public filings are not the only risks that we face.
        Additional risks and uncertainties not currently known to us, or that we
        presently deem to be immaterial, also may materially adversely affect our
        business, financial condition and results of operations. During the three
        months
        ended March 31, 2007, there were no material changes from risk factors
        previously disclosed in our Annual Report on Form 10-K for the year ended
        December 31, 2006.
  **It** **em
        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))10.17
              
              Separation
                  and Release Agreement between the Company and Jeremiah J. Fleming,
                  dated
                  as of March 7, 2007 (incorporated herein by reference from the
                  same
                  exhibit number to the Company’s Current Report on Form 8-K filed on March
                  9, 2007)10.20
              
              Letter
                  of Assignment between the Company and Pamela J. Hynes, dated as
                  of January
                  2, 2007(incorporated
                  herein by reference from the same exhibit number to the Company’s Annual
                  Report on Form 10-K for the year ended December 31,
                  2006)10.35
              
              Form
                  of Incentive Stock Option Agreement under 2006 Equity Incentive
                  Plan
                  (incorporated herein by reference from the same exhibit number
                  to the
                  Company’s Current Report on Form 8-K filed on February 22,
                  2007)10.36
              
              Form
                  of Nonqualified Stock Option Agreement under 2006 Equity Incentive
                  Plan
                  (incorporated herein by reference from the same exhibit number
                  to the
                  Company’s Current Report on Form 8-K filed on February 22,
                  2007)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 200231.2
              
              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 200232.1
              
              Certification
                  of the Chief Executive Officer, pursuant to 18 U. S. C. Section
                  1350, as
                  adopted pursuant to Section 906 of the Sarbanes-Oxley Act of
                  200232.2
              
              Certification
                  of the Chief Financial Officer, pursuant to 18 U. S. C. Section
                  1350, as
                  adopted pursuant to Section 906 of the Sarbanes-Oxley Act of
                  2002
 
 
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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:
                  May 10, 2007
              By:/s/
                  Stephen R. Head**Stephen
                  R. Head*****Chief
                  Financial Officer, Vice President of Finance
                  and******Administration,
                  Secretary and Treasurer******(Principal
                  Financial Officer and Principal Accounting
                  Officer)***
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