UNITED
STATES
 SECURITIES
AND EXCHANGE COMMISSION
 Washington,
D.C.  20549
 
 ____________
 
 FORM
10-Q
 
 (Mark
One)
 
 R
              QUARTERLY
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934
 
 For
the quarterly period ended September 30, 2008
 
 Or
 
 o
              TRANSITION
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934
 
 For
the transition period from ____________to____________
 
 Commission
File Number: 000-27385
   INTERACTIVE
INTELLIGENCE, INC.
 (Exact
name of registrant as specified in its charter)
 
 Indiana
                (State
      or other jurisdiction
                of
      incorporation or organization)
              
              35-1933097
                (I.R.S.
      Employer
                Identification
      No.)7601
      Interactive Way
                Indianapolis,
      IN 46278
                (Address
      of principal executive offices, including zip code)(317)
      872-3000
                (Registrant’s
      telephone number, including area code)Not
      Applicable(Former
      name, former address and former fiscal year, if changed since last
      report)
 
 Indicate by check mark whether the
registrant (1) has filed all reports required to be filed by Section 13 or 15(d)
of the Securities Exchange Act of 1934 during the preceding 12 months (or for
such shorter period that the registrant was required to file such reports), and
(2) has been subject to such filing requirements for the past 90
days. YesRNo*
  Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filer, a non-accelerated filer, or a smaller reporting company. See
the definitions of “large accelerated filer,” “accelerated filer” and “smaller
reporting company” in Rule 12b-2 of the Exchange Act. (Check One):
  Large
      accelerated filer
              *
              
              
              Accelerated
      filer
              RNon-accelerated
      filer
              *(Do not check if a
      smaller reporting company)
              Smaller
      reporting company
              *
  Indicate by check mark whether the
registrant is a shell company (as defined in Rule 12b-2 of the Exchange
Act). Yes * No R
 
 As of
October 31, 2008, there were  17,051,677shares outstanding of the registrant’s common stock, $0.01 par
value.
    
  
  
 TABLE OF
CONTENTS
 
 PART
      I. FINANCIAL INFORMATION
              PageItem
      1.
              Financial
      Statements.Condensed
      Consolidated Balance Sheets as of September 30, 2008 and December 31,
      2007
              3Condensed
      Consolidated Statements of Income for the Three and Nine Months Ended
      September 30, 2008 and 2007
              4Condensed
      Consolidated Statement of Shareholders’ Equity for the Nine Months Ended
      September 30, 2008
              5Condensed
      Consolidated Statements of Cash Flows for the Nine Months Ended September
      30, 2008 and 2007
              6Notes
      to Condensed Consolidated Financial Statements
              7Item
      2.
              Management’s
      Discussion and Analysis of Financial Condition and Results of
      Operations.
              13Item
      3.
              Quantitative
      and Qualitative Disclosures About Market Risk.
              19Item
      4.
              Controls
      and Procedures.
              20PART
      II. OTHER INFORMATIONItem
      1.
              Legal
      Proceedings.
              20Item
      1A.
              Risk
      Factors.
              20Item
      2.
              Unregistered
      Sales of Equity Securities and Use of Proceeds.
              20Item
      6.
              Exhibits.
              21SIGNATURE
              21
  2
  PART
I. FINANCIAL INFORMATION
 
 Item
1. Condensed Consolidated Financial Statements and Notes to Condensed
Consolidated Financial Statements.
 
 Interactive Intelligence, Inc.
 Condensed
Consolidated Balance Sheets
 As
of September 30, 2008 and December 31, 2007
 (In
thousands, except share and per share amounts)
 
 September
      30,
                  2008
              
              
              December
      31,
                2007(unaudited)
              
              
              (Note
      1)AssetsCurrent
      assets:Cash
      and cash equivalents
              
              $
              34,476
              
              
              $
              29,359Short-term
      investments
              
              
              14,845
              
              
              
              16,968Accounts
      receivable, net of allowance for doubtful accounts of
                $904
      at September 30, 2008 and $1,076 at December 31, 2007
              
              
              25,231
              
              
              
              27,527Deferred
      tax assets, net
              
              
              5,833
              
              
              
              5,833Prepaid
      expenses
              
              
              5,297
              
              
              
              5,501Other
      current assets
              
              
              2,513
              
              
              
              1,414Total
      current assets
              
              
              88,195
              
              
              
              86,602Property
      and equipment, net
              
              
              11,091
              
              
              
              6,932Deferred
      tax assets, net
              
              
              5,735
              
              
              
              7,520Other
      assets, net
              
              
              2,781
              
              
              
              2,384Total
      assets
              
              $
              107,802
              
              
              $
              103,438Liabilities
      and Shareholders’ EquityCurrent
      liabilities:Accounts
      payable and accrued liabilities
              
              $
              12,856
              
              
              $
              9,594Accrued
      compensation and related expenses
              
              
              3,589
              
              
              
              4,381Deferred
      product revenues
              
              
              5,104
              
              
              
              6,843Deferred
      services revenues
              
              
              28,611
              
              
              
              28,711Total
      current liabilities
              
              
              50,160
              
              
              
              49,529Noncurrent
      deferred services revenues
              
              
              6,151
              
              
              
              5,290Total
      liabilities
              
              
              56,311
              
              
              
              54,819Shareholders’
      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;
                17,749,984
      issued and outstanding at September 30, 2008
                and
      17,901,084 issued and outstanding at December 31, 2007
              
              
              177
              
              
              
              179Treasury
      stock
              
              
              (3,357
              )
              
              
              --Additional
      paid-in capital
              
              
              82,750
              
              
              
              79,405Accumulated
      deficit
              
              
              (28,079
              )
              
              
              (30,965
              )Total
      shareholders’ equity
              
              
              51,491
              
              
              
              48,619Total
      liabilities and shareholders’ equity
              
              $
              107,802
              
              
              $
              103,438
 
  See
Accompanying Notes to Condensed Consolidated Financial
Statements
  3
  Interactive Intelligence, Inc.
 Condensed
Consolidated Statements of Income (unaudited)
 For
the Three and Nine Months Ended September 30, 2008 and 2007
 (In
thousands, except per share amounts)
 
 Three
      Months Ended
                  September
      30,
              
              
              Nine
      Months Ended
                  September
      30,2008
              
              
              2007
              
              
              2008
              
              
              2007Revenues:Product
              
              $
              14,687
              
              
              $
              15,526
              
              
              $
              44,853
              
              
              $
              42,484Services
              
              
              15,369
              
              
              
              13,676
              
              
              
              45,296
              
              
              
              38,141Total
      revenues
              
              
              30,056
              
              
              
              29,202
              
              
              
              90,149
              
              
              
              80,625Cost
      of revenues:Product
              
              
              3,702
              
              
              
              4,232
              
              
              
              10,741
              
              
              
              10,173Services
              
              
              6,059
              
              
              
              5,533
              
              
              
              18,044
              
              
              
              15,475Total
      cost of revenues
              
              
              9,761
              
              
              
              9,765
              
              
              
              28,785
              
              
              
              25,648Gross
      profit
              
              
              20,295
              
              
              
              19,437
              
              
              
              61,364
              
              
              
              54,977Operating
      expenses:Sales
      and marketing
              
              
              9,569
              
              
              
              9,286
              
              
              
              29,889
              
              
              
              26,762Research
      and development
              
              
              5,801
              
              
              
              4,348
              
              
              
              16,102
              
              
              
              12,472General
      and administrative
              
              
              3,560
              
              
              
              3,310
              
              
              
              11,269
              
              
              
              9,660Total
      operating expenses
              
              
              18,930
              
              
              
              16,944
              
              
              
              57,260
              
              
              
              48,894Operating
      income
              
              
              1,365
              
              
              
              2,493
              
              
              
              4,104
              
              
              
              6,083Other
      income (expense):Interest
      income, net
              
              
              329
              
              
              
              412
              
              
              
              1,132
              
              
              
              1,268Other
      income (expense), net
              
              
              (71
              )
              
              
              29
              
              
              
              (26
              )
              
              
              (69
              )Total
      other income, net
              
              
              258
              
              
              
              441
              
              
              
              1,106
              
              
              
              1,199Income
      before income taxes
              
              
              1,623
              
              
              
              2,934
              
              
              
              5,210
              
              
              
              7,282Income
      tax benefit (expense)
              
              
              (699
              )
              
              
              37
              
              
              
              (2,324
              )
              
              
              (163
              )Net
      income
              
              $
              924
              
              
              $
              2,971
              
              
              $
              2,886
              
              
              $
              7,119Net
      income per share:Basic
              
              $
              0.05
              
              
              $
              0.17
              
              
              $
              0.16
              
              
              $
              0.41Diluted
              
              
              0.05
              
              
              
              0.15
              
              
              
              0.15
              
              
              
              0.37Shares
      used to compute net income per share:Basic
              
              
              17,976
              
              
              
              17,461
              
              
              
              17,969
              
              
              
              17,388Diluted
              
              
              18,855
              
              
              
              19,407
              
              
              
              19,059
              
              
              
              19,336
 
 
 See
Accompanying Notes to Condensed Consolidated Financial Statements
 
 
  4
  Interactive Intelligence, Inc.
 Condensed
Consolidated Statement of Shareholders’ Equity (unaudited)
 For
the Nine Months Ended September 30, 2008
 (In
thousands)
 
 AdditionalCommon
      Stock
              
              
              Paid-in
              
              
              Treasury
              
              
              AccumulatedShares
              
              
              Amount
              
              
              Capital
              
              
              Stock
              
              
              Deficit
              
              
              TotalBalances,
      December 31, 2007
              
              
              17,901
              
              
              $
              179
              
              
              $
              79,405
              
              
              $
              --
              
              
              $
              (30,965
              )
              
              $
              48,619Issuances
      of common stock
              
              
              15
              
              
              
              --
              
              
              
              205
              
              
              
              --
              
              
              
              --
              
              
              
              205Exercise
      of stock options
              
              
              187
              
              
              
              2
              
              
              
              715
              
              
              
              98
              
              
              
              --
              
              
              
              815Stock-based
      compensation
              
              
              --
              
              
              
              --
              
              
              
              2,315
              
              
              
              --
              
              
              
              --
              
              
              
              2,315Stock
      option income tax benefits
              
              
              --
              
              
              
              --
              
              
              
              177
              
              
              
              --
              
              
              
              --
              
              
              
              177Purchase
      of treasury stock
              
              
              (353
              )
              
              
              (4
              )
              
              
              --
              
              
              
              (3,455
              )
              
              
              --
              
              
              
              (3,459
              )Comprehensive
      income:Net
      income
              
              
              --
              
              
              
              --
              
              
              
              --
              
              
              
              --
              
              
              
              2,886
              
              
              
              2,886Net
      unrealized investment   loss
              
              
              --
              
              
              
              --
              
              
              
              (67
              )
              
              
              --
              
              
              
              --
              
              
              
              (67
              )Total
      comprehensive income
              
              
              --
              
              
              
              --
              
              
              
              (67
              )
              
              
              (3,357
              )
              
              
              2,886
              
              
              
              2,819Balances,  September
      30, 2008
              
              
              17,750
              
              
              $
              177
              
              
              $
              82,750
              
              
              $
              (3,357
              )
              
              $
              (28,079
              )
              
              $
              51,491
 
 
 See
Accompanying Notes to Condensed Consolidated Financial
Statements
  5
  Interactive Intelligence, Inc.
 Condensed
Consolidated Statements of Cash Flows (unaudited)
 For
the Nine Months Ended September 30, 2008 and 2007
 (In
thousands)
 
 Nine
      Months Ended
                September
      30,2008
              
              
              2007Operating
      activities:Net
      income
              
              $
              2,886
              
              
              $
              7,119Adjustments
      to reconcile net income to net cash provided by operating
      activities:Depreciation
              
              
              2,621
              
              
              
              1,941Stock-based
      compensation expense
              
              
              2,315
              
              
              
              2,286Deferred
      income tax
              
              
              1,785
              
              
              
              --Accretion
      of investment income
              
              
              (104
              )
              
              
              (317
              )Excess
      tax benefits from stock-based payment arrangements
              
              
              (177
              )
              
              
              --Changes
      in operating assets and liabilities:Accounts
      receivable
              
              
              2,296
              
              
              
              (8,191
              )Prepaid
      expenses
              
              
              204
              
              
              
              (617
              )Other
      current assets
              
              
              (1,099
              )
              
              
              216Other
      assets
              
              
              (397
              )
              
              
              (49
              )Accounts
      payable and accrued liabilities
              
              
              2,845
              
              
              
              1,192Accrued
      compensation and related expenses
              
              
              (792
              )
              
              
              662Deferred
      product revenues
              
              
              (1,505
              )
              
              
              908Deferred
      services revenues
              
              
              527
              
              
              
              4,682Net
      cash provided by operating activities
              
              
              11,405
              
              
              
              9,832Investing
      activities:Sales
      of available-for-sale investments
              
              
              20,050
              
              
              
              18,115Purchases
      of available-for-sale investments
              
              
              (17,890
              )
              
              
              (15,192
              )Purchases
      of property and equipment
              
              
              (6,186
              )
              
              
              (3,601
              )Acquisition
      of professional services division
              
              
              --
              
              
              
              (1,033
              )Net
      cash used in investing activities
              
              
              (4,026
              )
              
              
              (1,711
              )Financing
      activities:Proceeds
      from stock options exercised
              
              
              717
              
              
              
              1,628Proceeds
      from issuance of common stock
              
              
              205
              
              
              
              150Excess
      tax benefits from stock-based payment arrangements
              
              
              177
              
              
              
              --Repurchase
      of treasury stock
              
              
              (3,361
              )
              
              
              --Net
      cash provided by (used in) financing activities
              
              
              (2,262
              )
              
              
              1,778Net
      increase in cash and cash equivalents
              
              
              5,117
              
              
              
              9,899Cash
      and cash equivalents, beginning of period
              
              
              29,359
              
              
              
              13,531Cash
      and cash equivalents, end of period
              
              $
              34,476
              
              
              $
              23,430Cash
      paid during the period for:Income
      taxes
              
              $
              195
              
              
              $
              147Other
      non-cash item:Purchases
      of property and equipment payable at end of period
              
              $
              594
              
              
              $
              --
 
 See
Accompanying Notes to Condensed Consolidated Financial
Statements
  6
  Interactive Intelligence, Inc.
 Notes
to Condensed Consolidated Financial Statements
 September
30, 2008 and 2007 (unaudited)
 
 1.
              FINANCIAL
      STATEMENT PRESENTATION
  The
accompanying unaudited condensed consolidated financial statements of
Interactive Intelligence, Inc. (the “Company”) have been prepared in conformity
with accounting principles generally accepted in the United States of America
(“US GAAP”) and with the instructions for Form 10-Q and Article 10 of Regulation
S-X for interim financial information. Accordingly, certain information and note
disclosures normally included in the Company’s financial statements prepared in
accordance with US GAAP have been condensed, or omitted, pursuant to the rules
and regulations of the United States Securities and Exchange Commission (the
“SEC”).
 
 The
preparation of the Company’s condensed consolidated financial statements
requires management to make estimates and assumptions that affect reported
amounts of assets and liabilities, at the respective balance sheet dates, and
the reported amounts of revenues and expenses during the respective reporting
periods. Despite management’s best effort to establish good faith estimates and
assumptions, actual results could differ from these estimates. In management’s
opinion, the Company’s accompanying condensed consolidated financial statements
include all adjustments necessary (which are of a normal and recurring nature,
except as otherwise noted) for the fair presentation of the results of the
interim periods presented.
 
 The
Company’s accompanying condensed consolidated balance sheet as of December 31,
2007 has been derived from the Company’s audited consolidated financial
statements at that date but does not include all of the information and notes
required by US GAAP for complete financial statements. These accompanying
condensed consolidated financial statements should be read in conjunction with
the Company’s audited consolidated financial statements for the year ended
December 31, 2007, included in the Company’s most recent Annual Report on Form
10-K as filed with the SEC on March 17, 2008. The Company’s results of
operations for any interim period are not necessarily indicative of the results
of operations for any other interim period or for a full fiscal
year.
 
 Principles
of Consolidation
 
 The
accompanying condensed consolidated financial statements include the accounts of
the Company and its wholly-owned subsidiaries after elimination of all
significant intercompany accounts and transactions.
 
 Reclassifications
and Adjustments
 
 During
the second quarter of 2008, the Company identified an error in the
classification of the unearned premium/discount between cash and cash
equivalents and short-term investments.  In the December 31, 2007
balance sheet, $89,000 has been reclassified from cash and cash equivalents to
short-term investments. This reclassification did not have any impact on results
previously reported.
 
 Effective
March 31, 2008, in order to properly classify noncurrent deferred revenues from
the current portion, the Company reclassified $5.3 million of noncurrent
deferred revenues to a separate line item on the accompanying condensed
consolidated balance sheets. In addition, $582,000 of related prepaid
commissions associated with the Company’s noncurrent deferred revenues have also
been appropriately reclassified from the current portion of prepaid expenses and
included in noncurrent other assets, net. This error did not have any impact on
results previously reported.
 
 During
the fourth quarter of 2007, the Company identified an error that affected
amounts previously reported on its Quarterly Reports on Form 10-Q for the first
three 2007 quarterly periods.  During the first three 2007 quarterly
periods, the Company deferred maintenance and support revenues based on an
assumed 18 month maintenance and support period, but in certain cases the actual
support period was less than the maximum period. With respect to the three and
nine months ended September 30, 2007, the Company under-recognized product
revenues in the amount of $494,000 and $744,000, respectively, and related
commission expenses during the same periods were also under-recognized by
$54,000 and $82,000, respectively. This error did not have a material impact on
results previously reported.
 
 2.
              SUMMARY
      OF CERTAIN ACCOUNTING POLICIES AND RECENT ACCOUNTING
      PRONOUNCEMENTS
 
 The
Company’s interim critical accounting policies and estimates include the
recognition of income taxes using an estimated annual effective tax rate. For a
complete summary of the Company’s other significant accounting policies and
other critical accounting estimates, refer to Note 2 of Notes to Consolidated
Financial Statements included in the Company’s Annual Report on Form 10-K for
the year ended December 31, 2007.
 
 During
the nine months ended September 30, 2008, there were no material changes to the
Company’s significant accounting policies or critical accounting estimates other
than the recent accounting pronouncements discussed below.
 
 In May
2008, the Financial Accounting Standards Board (“FASB”) issued Statement of
Financial Accounting Standards (“SFAS”) No. 162, The Hierarchy of Generally Accepted
Accounting Principles(“SFAS 162”). SFAS 162 identifies the sources of
accounting principles and the framework for selecting the principles to be used
in the preparation of financial statements of nongovernmental entities that are
presented in conformity with US GAAP. SFAS 162 will be effective beginning
November 15, 2008. The Company is currently evaluating the potential impact, if
any, of the adoption of SFAS 162 on its consolidated financial
statements.
 
 7
  In
December 2007, the FASB issued SFAS No. 141 (revised 2007), Business Combinations(“SFAS
141R”) and SFAS No. 160, Noncontrolling Interests in
Consolidated Financial Statements– an amendment to ARB No. 51(“SFAS
160”). SFAS 141R and SFAS 160 require most identifiable assets, liabilities,
noncontrolling interests, and goodwill acquired in a business combination to be
recorded at “full fair value” and require noncontrolling interests (previously
referred to as minority interests) to be reported as a component of equity,
which changes the accounting for transactions with noncontrolling interest
holders. Both SFAS 141R and SFAS 160 are effective for periods beginning on
or after December 15, 2008, and earlier adoption is prohibited. SFAS 141R will
be applied to business combinations occurring after the effective date. SFAS 160
will be applied prospectively to all noncontrolling interests, including any
that arose before the effective date. The Company does not expect that the
adoption of SFAS 141R and SFAS 160 will have a material impact on its results of
operations and financial position.
  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 became
effective for the Company beginning January 1, 2008.  Upon adoption of
SFAS 159, there was no material impact on the Company’s condensed consolidated
financial statements.
 
 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, SFAS 157 does not require any new fair value measurements. SFAS 157
became effective for the Company beginning January 1, 2008. Upon adoption of
SFAS 157, there was no material impact on the Company’s condensed consolidated
financial statements.
 
 In
February 2008, the FASB issued FASB Staff Position (“FSP”) No. 157-2, Effective Date of FASB Statement No.
157 (“FSP 157-2”), which delays the effective date of SFAS 157 for one
year for all nonfinancial assets and nonfinancial liabilities, except those that
are recognized or disclosed at fair value in the financial statements on a
recurring basis. The Company elected a partial deferral of SFAS 157 under the
provisions of FSP 157-2 related to the measurement of fair value used when
evaluating goodwill, other intangible assets and other long-lived assets for
impairment. See Note 3 for further information and related disclosures regarding
the Company’s fair value measurements. Upon adoption of FSP 157-2, there was no
material impact on the Company’s condensed consolidated financial
statements.
 
 In
October 2008, the FASB issued FSP No. 157-3, Determining the Fair Value of a
Financial Asset When the Market for that Asset is Not Active(“FSP
157-3”), which clarifies the application of SFAS 157 in an inactive market. FSP
157-3 explains that when relevant and observable market information is not
available to determine the measurement of an asset’s fair value, management must
use their judgment about the assumptions a market participant would use in
pricing the asset in a current sale transaction.  Appropriate risk
adjustments that a market participant would use must also be taken into account
when determining the fair value. Application of this guidance should be
accounted for as a change in estimate and FSP 157-3 was effective upon issuance.
Upon adoption of FSP 157-3, there was no material impact on the Company’s
condensed consolidated financial statements.
 
 3.
              FAIR
      VALUE MEASUREMENTS
 
 SFAS 157
defines fair value as the exchange price that would be received for an asset or
paid to transfer a liability (an exit price) in the principal or most
advantageous market for the asset or liability in an orderly transaction between
market participants on the measurement date. SFAS 157 also establishes a fair
value hierarchy which requires an entity to maximize the use of observable
inputs and minimize the use of unobservable inputs when measuring fair value.
The standard describes the following three levels of inputs that may be used to
measure fair value:
 
 ·
              Level 1 - Unadjusted
      quoted prices in active markets that are accessible at the measurement
      date for identical, unrestricted assets or
  liabilities.
 
 ·
              Level 2 - Observable
      inputs other than Level 1 prices such as quoted prices for similar assets
      or liabilities; quoted prices in markets that are not active; or other
      inputs that are observable or can be corroborated by observable market
      data for substantially the full term of the assets or
      liabilities.
 
 ·
              Level 3 - Unobservable
      inputs that are supported by little or no market activity and that are
      significant to the fair value of the assets or
  liabilities.
  The
Company’s assets that are measured at fair value on a recurring basis are
generally classified within Level 1 or Level 2 of the fair value
hierarchy.  The types of instruments valued based on quoted market
prices in active markets include most money market securities and equity
investments.  Such instruments are generally classified within Level 1
of the fair value hierarchy.  The Company invests in money market
funds that are traded daily and does not adjust the quoted price for such
instruments.  The types of instruments valued based on quoted prices
in less active markets, broker or dealer quotations, or alternative pricing
sources with reasonable levels of price transparency include the Company’s
corporate notes, commercial paper, asset-backed securities and certificates of
deposits.  Such instruments are generally classified within Level 2 of
the fair value hierarchy.  The Company uses consensus pricing, which
is based on multiple pricing sources, to value its fixed income
investments.
 
 The
following table sets forth a summary of the Company’s financial assets,
classified as cash and cash equivalents and short-term investments on its
condensed consolidated balance sheet, measured at fair value on a recurring
basis as of September 30, 2008 (in thousands):
 8
 Fair
      Value Measurements at
                Reporting
      Date UsingDescription
              
              Total
              
              
              Quoted
      Prices in
                  Active
      Markets for
                  Identical
      Assets
                  (Level
      1)
              
              
              Significant
                  Other
      Observable
                  Inputs
                  (Level
      2)
              
              
              Significant
                  Unobservable
                  Inputs
                  (Level
      3)Cash
      & cash equivalents:Money
      Market Funds
              
              $
              24,151
              
              
              $
              24,151
              
              
              $
              --
              
              
              $
              --Short-term
      investments:Corporate
      Notes
              
              $
              6,690
              
              
              $
              --
              
              
              $
              6,690
              
              
              $
              --Commercial
      Paper
              
              
              6,355
              
              
              
              --
              
              
              
              6,355
              
              
              
              --Asset-Backed
      Securities
              
              
              800
              
              
              
              --
              
              
              
              800
              
              
              
              --Certificates
      of Deposits
              
              
              1,000
              
              
              
              --
              
              
              
              1,000
              
              
              
              --Total
              
              $
              14,845
              
              
              $
              --
              
              
              $
              14,845
              
              
              $
              --
 
 4.
              NET
      INCOME PER SHARE
 
 Basic net
income per share is calculated based on the weighted-average number of common
shares outstanding in accordance with SFAS No. 128, Earnings per Share. Diluted
net income per share is calculated based on the weighted-average number of
common shares outstanding plus the effect of dilutive potential common shares.
The calculation of diluted net income per share excludes shares underlying stock
options outstanding that would be anti-dilutive. Potential common shares are
composed of shares of common stock issuable upon the exercise of stock options.
The following table sets forth the calculation of basic and diluted net income
per share (in thousands, except per share amounts):
  Three
      Months Ended
                  September
      30,
              
              
              Nine
      Months Ended
                  September
      30,2008
              
              
              2007
              
              
              2008
              
              
              2007Net
      income, as reported (A)
              
              $
              924
              
              
              $
              2,971
              
              
              $
              2,886
              
              
              $
              7,119Weighted
      average shares of common stock outstanding (B)
              
              
              17,976
              
              
              
              17,461
              
              
              
              17,969
              
              
              
              17,388Dilutive
      effect of employee stock options
              
              
              879
              
              
              
              1,946
              
              
              
              1,089
              
              
              
              1,948Common
      stock and common stock equivalents (C)
              
              
              18,855
              
              
              
              19,407
              
              
              
              19,059
              
              
              
              19,336Net
      income per share:Basic
      (A/B)
              
              $
              0.05
              
              
              $
              0.17
              
              
              $
              0.16
              
              
              $
              0.41Diluted
      (A/C)
              
              
              0.05
              
              
              
              0.15
              
              
              
              0.15
              
              
              
              0.37
 
 The
Company’s calculation of diluted net income per share for the three months ended
September 30, 2008 and 2007 excludes stock options to purchase approximately 1.6
million and 756,000 shares of the Company’s common stock, respectively, and
diluted net income per share for the nine months ended September 30, 2008 and
2007 excludes stock options to purchase approximately 1.3 million and 618,000
shares of the Company’s common stock, respectively, as their effect would be
antidilutive.
 
 5.
              STOCK-BASED
      COMPENSATION
 
 Stock
Option Plans
 
 The
Company’s Stock Option Plans, adopted in 1995, 1999 and 2006, authorize the
Board of Directors or the Compensation Committee, as applicable, to grant
incentive and nonqualified stock options, and, in the case of the 2006 Equity
Incentive Plan, as amended (the “2006 Plan”), stock appreciation rights,
restricted stock, restricted stock units, performance shares, performance units
and other stock-based awards. After adoption of the original 2006 Plan by the
Company’s shareholders in May 2006, the Company may no longer make any grants
under previous plans, but any shares subject to awards under the 1999 Stock
Option and Incentive Plan and the Outside Directors Stock Option Plan
(collectively, the “1999 Plans”) that are cancelled are added to shares
available under the 2006 Plan. The exercise price of options granted under the
2006 Plan is equal to the closing price of the Company’s common stock, as
reported by The NASDAQ Global Market, on the business day immediately preceding
the date of grant. The number of shares available under the 2006 Plan is subject
to adjustment for certain changes in the Company’s capital
structure.
 
 At the
Company’s 2008 Annual Meeting of Shareholders held on May 30, 2008, the
Company’s shareholders approved an amendment to the 2006 Plan. A maximum of
5,850,933 shares are available for delivery under the 2006 Plan, which consists
of (i) the 2,150,000 shares, plus (ii) up to 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
Company currently issues two types of stock options: (1) non-executive employee
and director grants and (2) executive officer and sales management grants. Stock
options granted to non-executive employees and directors are subject only to
time-based vesting. The fair value of these option grants is determined on the
date of grant and the related compensation expense is recognized for the entire
award on a straight-line basis over the vesting period.
  9
  Performance-based
stock options are typically granted to executive officers and certain sales
management during the first quarter of the year with the grants subject to
cancellation if specified performance targets, as approved by the Company’s
Compensation Committee, are not achieved. If the applicable performance targets
have been achieved, the options will vest in four equal annual installments
beginning one year after the performance-related year has ended.
 
 The fair
value of the executive officer option grants is determined on the date of grant
and the related compensation expense is recognized over the requisite service
period, including the initial period for which the specified performance targets
must be met. Although the valuation assumptions used for executive officer
grants are similar to grants made to non-executive employee and director grants,
the assumptions for executive officer grants are used to measure each vesting
tranche of the awards.
 
 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
incentive stock option is granted to an employee who, at the time the option is
granted, owns stock representing more than 10% 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 Company’s Board of Directors at any time.
  Stock-Based
Compensation Expense Information
 
 The
following table summarizes the allocation of stock-based compensation expense
related to employee and director stock options under SFAS No. 123 (revised
2004), Share-Based
Payment, and the guidance of Staff Accounting Bulletin No. 107, as
amended by Staff Accounting Bulletin No. 110, for the three and nine months
ended September 30, 2008 and 2007 (in thousands):
 
 Three
      Months Ended
                  September
      30,
              
              
              Nine
      Months Ended
                  September
      30,2008
              
              
              2007
              
              
              2008
              
              
              2007Stock-based
      compensation expense by category:Cost
      of services
              
              $
              13
              
              
              $
              70
              
              
              $
              154
              
              
              $
              184Sales
      and marketing
              
              
              132
              
              
              
              313
              
              
              
              876
              
              
              
              943Research
      and development
              
              
              205
              
              
              
              157
              
              
              
              637
              
              
              
              419General
      and administrative
              
              
              89
              
              
              
              272
              
              
              
              648
              
              
              
              739Total
      stock-based compensation expense
              
              $
              439
              
              
              $
              812
              
              
              $
              2,315
              
              
              $
              2,285
 
 During
the third quarter of 2008, the Company determined that it was improbable that
the performance targets for any of the executive and certain sales management
performance-based awards granted at the beginning of 2008 would be met.
Therefore, during the third quarter of 2008, the Company stopped accruing stock
option expense and reversed stock option expense recorded in previous periods of
$432,000 related to these performance-based options.
  Valuation
Assumptions
 
 The
Company estimated the fair value of stock options using the Black-Scholes
valuation model. There were no material changes in the way the assumptions were
calculated, as previously disclosed in our Annual Report on Form 10-K for the
year ended December 31, 2007.  The weighted-average estimated per
option value of options granted to employees and directors for the nine months
ended September 30, 2008 and September 30, 2007 used the following
assumptions:
  Nine
      months ended
                  September
      30,
                
                Nine
      months ended
                  September
      30,Valuation
      assumptions for non-executive officer and director
      options:
                
                2008
                
                2007Dividend
      yield
                
                
                --
                %
                
                
                --
                %Expected
      volatility
                
                
                63.21
      - 65.72
                %
                
                
                61.18
      - 63.85
                %Risk-free
      interest rate
                
                
                2.22 –
      3.34
                %
                
                
                4.15
      – 5.02
                %Expected
      life of option (in years)
                4.25
      years
                
                4.25
      years
 
 Nine
      months ended
                    September
      30,
                
                Nine
      months ended
                  September
      30,Valuation
      assumptions for executive officer options:
                
                2008
                
                2007Dividend
      yield
                
                
                --
                %
                
                
                --
                %Expected
      volatility
                
                
                63.66
                %
                
                
                67.27
                %Risk-free
      interest rate
                
                
                2.39
                %
                
                
                4.48
                %Expected
      life of option (in years)
                
                4.75
      years
                
                4.75
      years
 
 10
  Stock
Option Activity
 
 The
following table sets forth a summary of option activity for the nine months
ended September 30, 2008:
 As
      of September 30, 2008Options
                
                
                Weighted-
                    Average
                    Exercise
                    PriceBalances,
      beginning of year
                
                
                3,232,483
                
                
                $
                8.71Options
      granted
                
                
                588,065
                
                
                
                15.22Options
      exercised
                
                
                (186,883
                )
                
                
                4.35Options
      cancelled
                
                
                (59,000
                )
                
                
                12.73Options
      outstanding, nine months ended
                
                
                3,574,665
                
                
                
                9.94Option
      price range
                
                $
                2.51
      - 50.50Weighted-average
      fair value of options granted during the nine months ended
                
                $
                7.80Options
      exercisable
                
                
                2,087,516
                
                
                $
                7.36Options
      available for grant
                
                
                1,133,719
  6.
              STOCK
      REPURCHASE PROGRAM
 
 On July
28, 2008, the Company’s Board of Directors approved a share repurchase program
to facilitate the repurchase of its common stock over the course of one
year.  Under this program, the Company may purchase shares of its
common stock up to a maximum aggregate purchase price of $10 million.
Repurchases may be made from time to time in the open market and in privately
negotiated transactions, based on business and market conditions under plans
designed to comply with Rule 10b5-1 and 10b-18 under the Securities Exchange Act
of 1934, as amended. The program may be amended, suspended or discontinued at
any time and does not commit the Company to repurchase shares of its common
stock.  Any shares acquired will be available for stock-based
compensation awards and other corporate purposes.
 
 During
the three months ended September 30, 2008, the Company repurchased 353,000
shares of its common stock at an aggregate cost of $3.4 million. As of September
30, 2008, approximately $6.6 million was available for future repurchases.
Through October 31, 2008, the Company has repurchased 1.1 million shares at an
aggregate cost of $9.0 million. Approximately $1.0 million was available for
future repurchases as of October 31, 2008.
  7.
              CONCENTRATION
      OF CREDIT RISK
 
 No
customer or partner accounted for 10% or more of the Company’s accounts
receivable as of September 30, 2008 or December 31, 2007. In addition, no
customer or partner accounted for 10% or more of the Company’s revenues for the
three and nine months ended September 30, 2008 and 2007. The Company manages its
operations as a single segment for purposes of assessing performance and making
operating decisions.
 
 8.
              COMMITMENTS
      AND CONTINGENCIES
 
 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.
 11
  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, which included the years 2002, 2003 and
2004.   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 September 30, 2008, the
assessment related to VAT for all years encompassed in the audit was
approximately $6 million and the assessment related to corporation taxes was
approximately $719,000.  As of September 30, 2008 and December 31,
2007, the Company has recorded an accrual for an amount it deems probable
of payment for the corporation tax assessment. No accrual has been made by
the Company with respect to the VAT assessment.  In addition, the
Company has filed for VAT refunds in France of more than $600,000, which the
Company has not recorded as a receivable.
  The
Company is negotiating with the French Taxing Authorities to settle the
dispute.  During the negotiations, the French Taxing Authorities
indicated that the Company would receive a VAT refund in return for paying all
the VAT owed.  The Company has agreed to offset the VAT refund it
would receive with the VAT expense that the French Taxing Authorities claim the
Company owes.  A condition of the negotiated settlement includes the
French Taxing Authorities releasing a portion of the $600,000 in VAT refunds the
Company has already claimed.  Due to the uncertainty of this
situation, the Company has made no additional accruals for gain or loss
contingencies related to the VAT and corporation taxes during the three and nine
months ended September 30, 2008.  The Company believes that the
matters should be settled within the first half of 2009, however the outcome is
difficult to predict and could change.
  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.
  Lease
Commitment
 
 The
Company leases its world headquarters building under an operating lease
agreement (“World Headquarters Lease”), which expires on March 31, 2018. The
120,000 square foot building is located in Indianapolis, Indiana. In addition,
on June 19, 2007 and March 14, 2008, the Company entered into the third and
fourth amendments, respectively, of its World Headquarters Lease under
which the current leased space is to be expanded in three installments through
March 2009 totaling approximately 80,000 square feet in an office building that
is adjacent to the Company’s world headquarters. Rent payments for the expanded
space commenced in March 2008. In October 2008 the Company entered into a fifth
amendment of its World Headquarters Lease under which the current leased space
in an office building adjacent to the Company’s world headquarters is to be
expanded by 300 square feet. Rent payments for this space commenced in September
2008. In consideration for entering into the amendments, the landlord paid the
Company a total discretionary allowance of $478,000. The allowance, which the
Company intends to use for certain costs associated with its world headquarters
building and/or the additional space, as defined in the amendment, will be
recognized as a reduction of rent expense over the term of the World
Headquarters Lease.
 
 Other
Contingencies
 
 The
Company has received and may continue to receive certain state and local 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 tax credits or payment of additional real estate taxes in the
case of the abatements. The Company does not believe that it will be subject to
payment of any money related to these taxes, however the Company cannot provide
assurance as to the outcome.
 
 9.
              INCOME
      TAXES
 
 The
following table is a reconciliation of the difference between the actual
provision for income taxes and the provision computed by applying the federal
statutory rate, 35%, on income before income taxes (in thousands):
  Three
      Months Ended
                      September
      30,
                  
                  
                  Nine
      Months Ended
                      September
      30,2008
                  
                  
                  2007
                  
                  
                  2008
                  
                  
                  2007Expected
      income tax expense
                  
                  $
                  (568
                  )
                  
                  $
                  (1,027
                  )
                  
                  $
                  (1,824
                  )
                  
                  $
                  (2,549
                  )State
      taxes, net of federal benefit
                  
                  
                  (81
                  )
                  
                  
                  (147
                  )
                  
                  
                  (261
                  )
                  
                  
                  (364
                  )Non-deductible
      stock-based compensation expense
                  
                  
                  (137
                  )
                  
                  
                  (165
                  )
                  
                  
                  (481
                  )
                  
                  
                  (506
                  )Non-deductible
      meals and entertainment expense
                  
                  
                  (37
                  )
                  
                  
                  (37
                  )
                  
                  
                  (112
                  )
                  
                  
                  (98
                  )Research and
      experimentation tax credit
                  
                  
                  169
                  
                  
                  
                  54
                  
                  
                  
                  169
                  
                  
                  
                  162Change
      in deferred tax asset valuation allowance
                  
                  
                  --
                  
                  
                  
                  1,359
                  
                  
                  
                  --
                  
                  
                  
                  3,192Other
                  
                  
                  (45
                  )
                  
                  
                  --
                  
                  
                  
                  185
                  
                  
                  
                  --Income
      tax benefit (expense)
                  
                  $
                  (699
                  )
                  
                  $
                  37
                  
                  
                  $
                  (2,324
                  )
                  
                  $
                  (163
                  )
 12
  Upon
adoption of FASB Interpretation No. 48, Accounting for Uncertainty in Income
Taxes an interpretation of FASB Statement No. 109, the Company has
identified an uncertain tax position related to the tax credits that the Company
currently believes meets the “more likely than not” recognition threshold to be
sustained upon examination. Prior to the fourth quarter of 2007, this uncertain
tax position had not been recognized because the Company had a valuation
allowance established. The balance of the unrecognized tax benefit was
approximately $328,000 at December 31, 2007 and, if recognized, would impact the
effective tax rate. As of September 30, 2008, the unrecognized tax benefit has
not changed.
 
 The
Company and its subsidiaries file federal income tax returns and income tax
returns in various states and foreign jurisdictions. Tax years 2004 and forward
remain open for examination for federal tax purposes and tax years 2003 and
forward remain open for examination for the Company’s more significant state tax
jurisdictions. To the extent utilized in future years’ tax returns, net
operating loss and capital loss carryforwards at December 31, 2007 will remain
subject to examination until the respective tax year is closed.
  Item 2.
              Management’s
      Discussion and Analysis of Financial Condition and Results of
      Operations.
 
 The
following Management’s Discussion and Analysis of Financial Condition and
Results of Operations is intended to provide our investors with an understanding
of our past performance, our financial condition and our prospects and should be
read in conjunction with other sections of this Quarterly Report on Form 10-Q.
Investors should carefully review the information contained in this report under
Part II, Item 1A “Risk Factors” and in the Item 1A “Risk Factors” section of our
Annual Report on Form 10-K for the fiscal year ended December 31, 2007. The
following will be discussed and analyzed:
  ·           Forward-Looking
Information
 
 ·           Overview
 
 ·           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, unstable economic conditions, 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 partners, 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,
2007.
 
 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, Indiana 46278. Our
telephone number is (317) 872-3000. You can find our website 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
website located at http://investors.inin.com
under “SEC Filings”.
 
 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
installed by customers in a wide range of industries including, but not limited
to, financial institutions, higher education, healthcare, retail, technology,
government, business services and increasingly for the remote and mobile
workforce.  We also offer a pre-integrated all-software Internet
Protocol Private Branch Exchange (“IP PBX”) system, a phone and communications
solution for mid- to large-sized enterprises that rely on the Microsoft
Corporation (“Microsoft”) platform. We offer innovative software products and
services for multi-channel contact management, business communications,
messaging, and VoIP solutions supported on the Session Initiation Protocol
(“SIP”) global communications standard. Many of our solutions can be deployed at
the customer’s site or can be provided in a Software as a Service (“SaaS”)
model.
 
 Our
application-based solutions are integrated on a platform developed to increase
security, broaden integration to business systems and end-user devices, enhance
mobility for today’s workforce, scale to thousands of users, and more wholly
satisfy today’s diverse interaction needs in markets for:
 
 ·
              Contact
      Centers
 
 ·
              Enterprise
      IP Telephony
 
 ·
              Enterprise
      Messaging
 13
 By
implementing our all-in-one solutions, businesses are able to unify
multi-channel communications media, enhance workforce effectiveness and
productivity, and more readily adapt to constantly-changing market and customer
requirements. Moreover, organizations in every industry are able to reduce the
cost and complexity of traditional “multi-point” legacy communications hardware
systems that are seldom fully integrated.
  For
further information on our business and the products and services we offer,
refer to the Item 1 “Business” section of our Annual Report on Form 10-K for the
year ended December 31, 2007.
  Financial
Highlights
 
 The
information below shows our total revenues (in millions) for the most recent
five quarters and the years ended December 31, 2007, 2006 and 2005 and the
percentage change over the previous period.
 
 IncreasePeriod
              
              Revenues
              
              
              (Decrease)%Three Months
      Ended:September
      30, 2008
              
              $
              30.1
              
              
              
              (2
              )%June
      30, 2008
              
              
              30.6
              
              
              
              4
              %March
      31, 2008
              
              
              29.5
              
              
              
              1
              %December
      31, 2007
              
              
              29.3
              
              
              
              0
              %September
      30, 2007
              
              
              29.2
              
              
              
              8
              %Year Ended December
      31:2007
              
              $
              109.9
              
              
              
              32
              %2006
              
              
              83.0
              
              
              
              32
              %2005
              
              
              62.9
              
              
              
              14
              %
 
 Product
orders in the first quarter of 2008 were up 39% compared to the same period in
2007.  Product orders were down 13% and 4% in the second and third
quarters of 2008, respectively, compared to the same periods in 2007. We have
received increased orders from new customers each of the first three quarters of
2008 compared to 2007; however, orders from existing customers decreased as many
existing customers limited expansions of our systems in response to economic
conditions. Product revenues may fluctuate from quarter to quarter depending on
the mix of orders between perpetual licenses and annually renewable
licenses.
 During
the three and nine months ended September 30, 2008, service revenues increased,
compared to the same periods in 2007, as a result of our growing installed base
of customers, both in number and dollar amount of licenses, and the revenue
recognition of related annual license renewal fees and support fees for
perpetual licenses. This increase was also due to an increase in revenues from
education and SaaS, as more partners and customers participated in our globally
expanding training sessions and more customers purchased our SaaS
solution.
  Operating
expenses increased in the three and nine months ended September 30, 2008,
compared to the same periods in 2007, primarily due to increases of $1.6 million
and $6.4 million, respectively, in salaries related to growth of 14% in our
worldwide staff.  Operating expenses also increased due to an increase
in referral fees and foreign exchange losses for the three and nine months ended
September 30, 2008 compared to the three and nine months ended September 30,
2007. Referral fees are fees paid to certain third parties for customer
referrals related to product sales; foreign exchange gains and losses relate to
the exchange gain or loss that results from foreign currency receipts. General
corporate allocable costs, which include rent, insurance and depreciation
increased for the three and nine months ended September 30, 2008 compared to the
same periods in 2007 due to additional offices opening in 2008.  In
March 2008, we relocated staff from another facility into one floor of
a new building adjacent to our world headquarters and in September 2008 we
expanded into an additional floor in the same building. We have also opened or
expanded offices domestically and internationally.
 
 Research
and development expense increased for the three and nine months ended September
30, 2008 compared to the same periods in 2007 by $1.4 million and $3.6 million,
respectively. We continue to believe that investment in research and
development, even in these uncertain economic conditions, is critical to
extending our competitive position in the marketplace and accelerating our
future growth.
 
 On July
28, 2008, our Board of Directors approved a share repurchase program. Under the
share repurchase program, we may purchase our common stock for up to a maximum
aggregate purchase price of $10 million from time to time over the next year
During the three months ended September 30, 2008, we repurchased 353,000
shares of our common stock for an aggregate cost of $3.4 million at an average
price of $9.82 per share. We did not repurchase any of our common stock during
2007.
 
 During
the nine months ended September 30, 2008, stock option expense increased by
$29,000 compared to the nine months ended September 30, 2007. Although the
expense in total did not materially change, the quarter to quarter expenses did.
During the first three quarters of 2008, stock option expense amounted to
$932,000, $944,000 and $439,000, respectively. Stock option expense for the
first three quarters in 2007 was $668,000, $806,000 and $812,000, respectively.
The greatest variance occurred during the third quarter of 2008, compared to the
third quarter of 2007. This difference was due to the fact that the company
stopped accruing stock option expense and reversed the expense recorded in
previous periods related to certain performance-based options as it was
determined that it was improbable that the performance targets would be
met.
 
 We have
seen a slowdown in orders during the last three quarters due to the current
economic conditions. We plan to carefully monitor expenses until the order
volume increases on a year-over-year basis.
 
 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 and nine months ended September
30, 2008 and 2007 are not necessarily indicative of the results that may be
expected for the full year or for any future period.
 14
 Three
      Months Ended
                  September
      30,
              
              
              Nine
      Months Ended
                September
      30,2008
              
              
              2007
              
              
              2008
              
              
              2007Revenues:Product
              
              
              49
              %
              
              
              53
              %
              
              
              50
              %
              
              
              53
              %Services
              
              
              51
              
              
              
              47
              
              
              
              50
              
              
              
              47Total
      revenues
              
              
              100
              
              
              
              100
              
              
              
              100
              
              
              
              100Cost
      of revenues:Product
              
              
              12
              
              
              
              14
              
              
              
              12
              
              
              
              13Services
              
              
              20
              
              
              
              19
              
              
              
              20
              
              
              
              19Total
      cost of revenues
              
              
              32
              
              
              
              33
              
              
              
              32
              
              
              
              32Gross
      profit
              
              
              68
              
              
              
              67
              
              
              
              68
              
              
              
              68Operating
      expenses:Sales
      and marketing
              
              
              32
              
              
              
              32
              
              
              
              33
              
              
              
              33Research
      and development
              
              
              19
              
              
              
              15
              
              
              
              18
              
              
              
              16General
      and administrative
              
              
              12
              
              
              
              11
              
              
              
              12
              
              
              
              12Total
      operating expenses
              
              
              63
              
              
              
              58
              
              
              
              63
              
              
              
              61Operating
      income
              
              
              5
              
              
              
              9
              
              
              
              5
              
              
              
              7Other
      income (expense):Interest
      income, net
              
              
              1
              
              
              
              1
              
              
              
              1
              
              
              
              2Other
      income (expense), net
              
              
              --
              
              
              
              --
              
              
              
              --
              
              
              
              --Total
      other income
              
              
              1
              
              
              
              1
              
              
              
              1
              
              
              
              2Income
      before income taxes
              
              
              6
              
              
              
              10
              
              
              
              6
              
              
              
              9Income
      tax expense
              
              
              (3
              )
              
              
              --
              
              
              
              (3
              )
              
              
              --Net
      income
              
              
              3
              %
              
              
              10
              %
              
              
              3
              %
              
              
              9
              %
 
 Comparison
of Three and Nine Months Ended September 30, 2008 and 2007
 
 Revenues
 Three
      Months Ended
              
              
              Nine
      Months EndedProduct
      Revenues
              
              September
      30,
              
              
              September
      30,2008
              
              
              2007
              
              
              2008
              
              
              2007($
      in thousands)Product
      revenues
              
              $
              14,687
              
              
              $
              15,526
              
              
              $
              44,853
              
              
              $
              42,484Change
      from prior year period
              
              
              (5
              )%
              
              
              30
              %
              
              
              6
              %
              
              
              40
              %Percentage
      of total revenues
              
              
              49
              %
              
              
              53
              %
              
              
              50
              %
              
              
              53
              %
 
 Product
revenues, which include software and hardware, decreased $839,000 during the
three months ended September 30, 2008 compared to the same period in 2007,
primarily because our existing customers are not licensing as many additional
users or expanding functionality of our systems compared to the prior year. In
the three months ended September 30, 2008, orders from existing customers
decreased by 20% compared to our existing customer orders in the same period in
2007. This decrease was substantially offset by a 25% increase in orders from
new customers in the three months ended September 30, 2008 compared to the same
period in 2007.
 
 Product
revenues increased $2.4 million for the nine months ended September 30, 2008
compared to the same period in 2007 due mostly to an increase in the dollar
amount of orders received. During the nine months ended September 30, 2008,
compared to the nine months ended September 30, 2007, we experienced an increase
in orders from new customers that more than offset the decrease in orders from
existing customers.
 
 Product
revenues can fluctuate from quarter to quarter depending on the mix of orders
between perpetual licenses and annually renewable licenses. 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 allocated entirely to services revenues.
 
 Services
      Revenues
              
              Three
      Months Ended
                  September
      30,
              
              
              Nine
      Months Ended
                  September
      30,2008
              
              
              2007
              
              
              2008
              
              
              2007($
      in thousands)Services
      revenues
              
              $
              15,369
              
              
              $
              13,676
              
              
              $
              45,296
              
              
              $
              38,141Change
      from prior year period
              
              
              12
              %
              
              
              36
              %
              
              
              19
              %
              
              
              33
              %Percentage
      of total revenues
              
              
              51
              %
              
              
              47
              %
              
              
              50
              %
              
              
              47
              %
 
 Services revenues include the portion
of the initial license arrangement allocated to maintenance and support revenues
from annually renewable and perpetual contracts, license renewals of annually
renewable contracts, and support fees for perpetual contracts, as well as
professional services, educational services and SaaS
offerings.
 
 15
  The
increase during the three and nine months ended September 30, 2008 compared to
the same periods in 2007 was primarily due to our growing installed base of
customers, both in number and dollar amount of licenses, and the revenue
recognition of related annual license renewal fees and support fees for
perpetual licenses. License renewal and support revenues increased by $1.8
million, or 18%, and $6.4 million, or 23%, during the three and nine months
ended September 30, 2008, respectively, compared to the same periods in 2007. As
we sign contracts and install our solutions with new customers, we expect that
our services revenues will continue to increase as customers renew licenses and
pay for support on our software applications. 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.
  During
the third quarter of 2008, our professional services revenues decreased
$785,000, or 32%, but our educational and SaaS services increased $636,000,
or 56%, compared to the same period in 2007. For the nine months ended September
30, 2008, our professional services revenues decreased $1.2 million, or 19%, and
education revenues and SaaS services increased $1.8 million, or 54%,
compared to the same period in 2007. Professional services revenues fluctuate
based on the amount of assistance our customers and partners contract with us
for implementation and installation.  Education revenues and SaaS
services increased primarily due to more partners and customers attending our
globally expanding training sessions and additional SaaS
agreements.
 
 Although
we have not experienced a significant increase in our customers choosing not to
renew their licenses and support fees, if more of our customers choose to not
renew, those decisions could have an adverse effect on our future services
revenue.
  Cost
      of Revenues
              
              Three
      Months Ended
                  September
      30,
              
              
              Nine
      Months Ended
                  September
      30,2008
              
              
              2007
              
              
              2008
              
              
              2007($
      in thousands)Cost
      of revenues:Product
              
              $
              3,702
              
              
              $
              4,232
              
              
              $
              10,741
              
              
              $
              10,173Services
              
              
              6,059
              
              
              
              5,533
              
              
              
              18,044
              
              
              
              15,475Total
      cost of revenues
              
              $
              9,761
              
              
              $
              9,765
              
              
              $
              28,785
              
              
              $
              25,648Change
      from prior year period
              
              
              0
              %
              
              
              49
              %
              
              
              12
              %
              
              
              58
              %Product
      costs as a % of product revenues
              
              
              25
              %
              
              
              27
              %
              
              
              24
              %
              
              
              24
              %Services
      costs as a % of services revenues
              
              
              39
              %
              
              
              40
              %
              
              
              40
              %
              
              
              41
              %
  Costs of product consist of hardware
costs, principally for media server and interaction gateway appliances which we
have developed; servers, telephone handsets and gateways which we purchase and
resell; royalties for third party software and other technologies included in
our solutions; personnel costs; and, to a lesser extent, software packaging
costs, which include product media, duplication and documentation. Costs of
product can fluctuate depending on which software applications are licensed to
our customers, the third party software that is licensed by the end user from us
as part of our software applications and the dollar amount of orders for
hardware.
 
 The
decrease in cost of products resulted from an $800,000 decrease in hardware cost
of goods sold, partially offset by a $236,000 increase in third party software
costs for the three months ended September 30, 2008 compared to the three months
ended September 30, 2007. For the nine months ended September 30, 2008, hardware
cost of goods sold, royalties and third party software increased in total by
$492,000 compared to the nine months ended September 30, 2007.
 
 The cost
of services consists primarily of compensation expenses for technical support,
educational and professional services personnel and other costs associated with
supporting our partners and customers. The cost of services increased primarily
due to a $254,000 increase in services compensation expense as a result of a 7%
staffing increase for the three months ended September 30, 2008 compared to the
three months ended September 30, 2007. Depreciation expense increased $86,000
for the three months ended September 30, 2008, compared to the same period in
2007, due to an increase in fixed assets; and we incurred additional costs of
$119,000 related to a professional services implementation.
  Compensation
expense increased by $1.8 million, which was partially offset by a $434,000
decrease in outsourced services expense for the nine months ended September 30,
2008 compared to the nine months ended September 30, 2007. Depreciation expense
increased $314,000 for the nine months ended September 30, 2008, compared to the
same period in 2007 due to an increase in fixed assets. SaaS telecommunications
expense increased $162,000 for the nine months ended September 30, 2008,
compared to the nine months ended September 30, 2007. The need for outsourced
services decreased during the nine months ended September 30, 2008 compared to
the prior year as a result of our ability to deliver services using
the increased number of our professional services staff.
  Gross
      Profit
              
              Three
      Months Ended
                  September
      30,
              
              
              Nine
      Months Ended
                  September
      30,2008
              
              
              2007
              
              
              2008
              
              
              2007($
      in thousands)Gross
      profit
              
              $
              20,295
              
              
              $
              19,437
              
              
              $
              61,364
              
              
              $
              54,977Change
      from prior year period
              
              
              4
              %
              
              
              26
              %
              
              
              12
              %
              
              
              28
              %Percentage
      of total revenues
              
              
              68
              %
              
              
              67
              %
              
              
              68
              %
              
              
              68
              %
 
 Gross
profit as a percentage of total revenues increased slightly during the three
months ended September 30, 2008, and remained consistent during the nine months
ended September 30, 2008, compared to the same periods in 2007. Gross margins in
any particular quarter are dependent upon revenues recognized versus costs of
product and costs of services incurred and are expected to vary.
 
 16
  Operating
Expenses
 Sales
      and Marketing
              
              Three
      Months Ended
                  September
      30,
              
              
              Nine
      Months Ended
                  September
      30,2008
              
              
              2007
              
              
              2008
              
              
              2007($
      in thousands)Sales
      and marketing expenses
              
              $
              9,569
              
              
              $
              9,286
              
              
              $
              29,889
              
              
              $
              26,762Change
      from prior year period
              
              
              3
              %
              
              
              23
              %
              
              
              12
              %
              
              
              26
              %Percentage
      of total revenues
              
              
              32
              %
              
              
              32
              %
              
              
              33
              %
              
              
              33
              %Percentage
      of net product revenues
              
              
              87
              %
              
              
              82
              %
              
              
              88
              %
              
              
              83
              %
 
 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. Sales and marketing compensation expense
increased $445,000 during the three months ended September 30, 2008 compared to
the same period in 2007, due to an 11% staffing increase in sales and marketing
personnel and an increase of $131,000 in referral fees. Referral fees are
sometimes paid to third parties for customer referrals related to product sales.
These increases were partially offset by a decrease in marketing related event
costs of $235,000 for the three months ended September 30, 2008 compared to the
same period in 2007.
  Sales and
marketing compensation expense increased $1.5 million during the nine months
ended September 30, 2008 compared to the same period in 2007 primarily due to a
staffing increase in our sales and marketing personnel as of September 30, 2008
compared to September 30, 2007. In addition, fees paid to certain third parties
for customer referrals increased by $437,000 for the nine months ended September
30, 2008 compared to the same period in 2007. Outsourced services, primarily
related to assistance with lead generation, increased by $261,000 for the nine
months ended September 30, 2008 compared to the same period in 2007, which
related mainly to an increase in marketing efforts. Corporate marketing expenses
increased by $226,000 for the nine months ended September 30, 2008 compared to
the same period in 2007 due to an increase in advertising, public relations, and
marketing related events from efforts to continue to increase our brand
awareness and distribution.
 
 Research
      and Development
              
              Three
      Months Ended
                  September
      30,
              
              
              Nine
      Months Ended
                  September
      30,2008
              
              
              2007
              
              
              2008
              
              
              2007($
      in thousands)Research
      and development expenses
              
              $
              5,801
              
              
              $
              4,348
              
              
              $
              16,102
              
              
              $
              12,472Change
      from prior year period
              
              
              33
              %
              
              
              24
              %
              
              
              29
              %
              
              
              26
              %Percentage
      of total revenues
              
              
              19
              %
              
              
              15
              %
              
              
              18
              %
              
              
              16
              %
 
 Research
and development expenses are comprised primarily of compensation, rent and
depreciation expenses. Research and development expenses increased during the
three months ended September 30, 2008, as compared to the same period in 2007,
primarily due to an increase in research and development compensation expense of
$1.0 million, resulting from a 25% staffing increase in our research and
development personnel at September 30, 2008 compared to September 30, 2007. In
addition, the allocated rent expense increased by $165,000 due to staff
additions in the research and development department and depreciation expense
increased $67,000 for the three months ended September 30, 2008 compared to the
same period in 2007 due to an increase in property, plant and
equipment.
 
 During
the nine months ended September 30, 2008, compensation expense increased $2.7
million compared to the nine months ended September 30, 2007 due to the
increase in research and development staffing at September 30, 2008 compared to
September 30, 2007. For the
nine months ended September 30, 2008 compared to the same period in 2007,
allocated rent and communication costs increased by $356,000 and $97,000,
respectively; depreciation expense increased $220,000; and outsourced
services related to the localization of our products increased by
$164,000.
  We
believe that investment in research and development is critical to our future
growth and competitive position in the marketplace and is directly related to
timely development of new and enhanced solutions that are central to our
business. As a result, we expect research and development expenses will increase
in future periods.
 
 General
      and Administrative
              
              Three
      Months Ended
                  September
      30,
              
              
              Nine
      Months Ended
                  September
      30,2008
              
              
              2007
              
              
              2008
              
              
              2007($
      in thousands)General
      and administrative expenses
              
              $
              3,560
              
              
              $
              3,310
              
              
              $
              11,269
              
              
              $
              9,660Change
      from prior year period
              
              
              8
              %
              
              
              21
              %
              
              
              17
              %
              
              
              19
              %Percentage
      of total revenues
              
              
              12
              %
              
              
              11
              %
              
              
              13
              %
              
              
              12
              %
  General
and administrative expenses are comprised of compensation expense and general
corporate expenses that are not allocable to other departments, such as legal
and other professional fees and bad debt expense. General and administrative
expenses increased during the three and nine months ended September 30, 2008, as
compared to the same periods in 2007, due to an increase in foreign exchange
losses of $178,000 and $120,000, respectively, and an increase in bad debt
expense of $100,000 and $97,000, respectively, due to the general economic
conditions. Salary expense decreased for the three months ended September 30,
2008 compared to the same period in 2007 by $111,000 mostly due to a decrease in
incentive stock option expenses, but increased overall for the nine months ended
September 30, 2008 compared to the nine months ended September 30, 2007 by
$509,000. The increase for the nine month period was due to an increase in
staffing in the general and administrative department.
  17
  Other
Income (Expense)
 
 Interest
      Income, Net
              
              Three
      Months Ended
                  September
      30,
              
              
              Nine
      Months Ended
                  September
      30,2008
              
              
              2007
              
              
              2008
              
              
              2007($
      in thousands)Cash,
      cash equivalents and short-term investments (average)
              
              $
              49,486
              
              
              $
              33,261
              
              
              $
              47,824
              
              
              $
              30,733Interest
      income
              
              
              329
              
              
              
              412
              
              
              
              1,132
              
              
              
              1,268Return
      on investment (annualized)
              
              
              2.66
              %
              
              
              4.95
              %
              
              
              3.16
              %
              
              
              5.50
              %
  Interest
earned on investments during the three and nine months ended September 30, 2008,
compared to the same periods in 2007, decreased due to lower interest rates as a
result of decreases in interest yields on investments. We continue to monitor
the allocation of funds in which we have invested to maximize our return on
investment while utilizing safe investment alternatives within our established
investment policy. We had short-term investments of $14.8 million as of
September 30, 2008, compared to $17.0 million as of December 31, 2007. We do not
have any investments in subprime assets.
 
 Other Income (Expense),
      Net
              
              Three
      Months Ended
                  September
      30,
              
              
              Nine
      Months Ended
                  September
      30,2008
              
              
              2007
              
              
              2008
              
              
              2007($
      in thousands)Other
      income (expense), net
              
              $
              (71
              )
              
              $
              29
              
              
              $
              (26
              )
              
              $
              (69
              )
 
 Other
income (expense), net includes foreign currency transaction gains and losses, as
well as foreign tax withholdings prior to 2008. Foreign currency transaction
gains and losses can fluctuate based on the strength of the dollar, particularly
against the Euro and British pound.
 
 During
the three months ended September 30, 2008, we determined that we would make an
election in our 2008 federal tax return to treat the foreign withholding tax as
a credit instead of as a deduction, which has been the historical election. As
such, we reversed the expense recorded for the foreign withholding tax in the
first two quarters of 2008 totaling $188,000 and have recognized deferred tax
assets for the foreign withholding tax credit as of September 30, 2008. Foreign
exchange losses increased for the three months ended September 30, 2008,
compared to the same period in 2007.
  Income
      tax expense
              
              Three
      Months Ended
                  September
      30,
              
              
              Nine
      Months Ended
                  September
      30,2008
              
              
              2007
              
              
              2008
              
              
              2007($
      in thousands)Income
      tax benefit (expense)
              
              $
              (699
              )
              
              $
              37
              
              
              $
              (2,324
              )
              
              $
              (163
              )
 
 As a
result of our recording an income tax benefit of $8.1 million in December 2007
to reduce the valuation allowance of our deferred tax assets, we began recording
income tax expense in the first quarter of 2008. We recorded $699,000 and $2.3
million of income tax expense during the three and nine months ended September
30, 2008, respectively; however, only $64,000 and $212,000 of the income tax
expense recorded for the three and nine months ended September 30, 2008,
respectively, is expected to result in cash payments, with the remainder
representing the impact of utilizing the deferred tax assets.
 
 We had
over $45.5 million of tax net operating loss carryforwards and $1.6 million in
tax credit carryforwards at December 31, 2007. Included in the net operating
loss carryforwards was $23.1 million of operating losses that were generated as
a result of compensation for tax purposes for stock option exercises. In
accordance with SFAS 123R, these stock option compensation deductions have not
been recognized for financial reporting purposes because they have not yet
reduced taxes payable. The tax benefit of these deductions will be primarily
recorded as a credit to additional paid-in capital if and when realized. The
effective income tax rate was 43.9% as of September 30, 2008. However, due to
the tax net operating loss carryforwards, the tax credit carryforwards and stock
option related compensation deductions, we do not expect to make significant
cash payments for income taxes in 2008.
 
 Liquidity
and Capital Resources
  Our
liquidity position at September 30, 2008 and December 31, 2007 was as
follows:
 
 September
      30,
              
              
              December
      31,2008
              
              
              2007($
      in thousands)Cash
      and cash equivalents
              
              $
              34,475
              
              
              $
              29,359Short-term
      investments
              
              
              14,845
              
              
              
              16,968Liquidity,
      net
              
              $
              49,320
              
              
              $
              46,327
 
 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 use cash primarily for paying our
employees (including salaries, commissions and benefits), leasing office space,
paying marketing and travel expenses, paying vendors for hardware, other
services and supplies, purchasing property and equipment and, beginning in the
third quarter of 2008, repurchasing our common stock. We continue to be debt
free.
  18
  We
determine liquidity by combining cash and cash equivalents and short-term
investments as shown in the table below. Based on our recent performance and
current expectations, we believe that our current liquidity position, when
combined with our anticipated cash flows from operations, will be sufficient to
satisfy our working capital needs, capital expenditures, investment
requirements, contractual obligations, commitments and other liquidity
requirements associated with our operations 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. In
doing so, we may not be able to receive favorable terms in raising this
capital.
  On
October 31, 2007, our shelf registration statement on Form S-3, as amended, was
declared effective by the SEC. This registration statement allows us to offer
and sell up to 3,000,000 shares of our common stock, and allows Donald E. Brown,
our Chairman of the Board, President and CEO, to sell up to 1,000,000 shares of
our common stock that he owns, from time to time in one or more transactions.
The offer and sale of any shares of our common stock under the shelf
registration statement remains at the discretion of our Board of Directors, and
there is no assurance that we would be able to complete any such offering of our
common stock.
 
 On July
28, 2008, we announced the approval of a share repurchase program by our Board
of Directors. Under the share repurchase program, we may repurchase our common
stock for up to a maximum aggregate purchase price of $10 million from time to
time over the next year. Any repurchases that we make will be made using our
cash resources. During the three months ended September 30, 2008, we
repurchased 353,000 shares of our common stock for an aggregate cost of $3.4
million at an average price of $9.82 per share. As of September 30, 2008, we had
the authority to purchase an additional $6.6 million of our common stock under
the plan approved by the Board of Directors. Through October 31, 2008, the
Company has repurchased 1.1 million shares at an aggregate cost of $9.0 million.
Approximately $1.0 million was available for future repurchases as of October
31, 2008.
  The
amount that we report as cash and cash equivalents or as short-term investments
fluctuates depending on investing decisions in each period. Purchases of
short-term investments and property and equipment are reported as a use of cash
and the related receipt of proceeds upon maturity of investment is reported as a
source of cash.
 
 During
the nine months ended September 30, 2008 and 2007, our operating activities
resulted in net cash provided of $11.4 million and $9.8 million,
respectively.
 
 Net cash
used in investing activities was $4.0 million and $1.7 million during the nine
months ended September 30, 2008 and 2007, respectively. We purchased property
and equipment with a cost of $6.2 and $3.6 million during the nine months ended
September 30, 2008 and 2007, respectively. During the last two years, we have
opened or expanded offices domestically and internationally.
 
 Net cash
used in financing activities was $2.3 million for the nine months ended
September 30, 2008.  Net cash provided by financing activities was
$1.8 million for the nine months ended September 30, 2007. The decrease in cash
provided was mainly due to the repurchase of our common stock, which began in
July 2008.
 
 As of
September 30, 2008, there have been no material changes in our contractual
obligations as set forth in the Contractual Obligations table disclosed in our
Annual Report on Form 10-K for the year ended December 31,
2007.
 
 Off-Balance
Sheet Arrangements
 
 Except as
set forth in the Contractual Obligations table disclosed in our Annual Report on
Form 10-K for the year ended December 31, 2007, we have no off-balance sheet
arrangements that have or are reasonably likely to have a current or future
material impact on our financial condition, changes in financial condition,
revenues or expenses, results of operations, liquidity, capital expenditures or
capital resources as of September 30, 2008.
 
 Critical
Accounting Policies and Estimates
  The
preparation of our condensed consolidated financial statements requires us to
make estimates and judgments that affect the reported amount of assets,
liabilities, revenue and expenses. Actual results may differ from those
estimates and judgments under different assumptions or conditions. We have
discussed the critical accounting policies that we believe affect our more
significant estimates and judgments used in the preparation of our consolidated
financial statements in the “Management’s Discussion and Analysis of Financial
Condition and Results of the Operations—Critical Accounting Policies and
Estimates” section of our Annual Report on Form 10-K for the year ended December
31, 2007 and in Note 2 of Notes to Consolidated Financial Statements included in
our Annual Report on Form 10-K for the year ended December 31, 2007. For a
further summary of certain accounting policies, see Note 2 of Notes to Condensed
Consolidated Financial Statements included in Part I, Item 1 of this Quarterly
Report on Form 10-Q.
 
 Item 3.
              Quantitative
      and Qualitative Disclosures about Market
Risk.
 
 We
develop software application products in the United States and license our
products worldwide. As a result, our financial results could be affected by
various factors, including changes in foreign currency exchange rates or weak
economic conditions in certain markets. We transact business in certain foreign
currencies including the British pound and the Euro. However, as a majority of
the orders we receive are denominated in United States dollars, a strengthening
of the dollar could make our products more expensive and less competitive in
foreign markets. We have not historically used foreign currency options or
forward contracts to hedge our currency exposures because of variability in the
timing of cash flows associated with our larger contracts. We did not have any
such hedge instruments in place at September 30, 2008. Rather, we attempt to
mitigate our foreign currency risk by generally transacting business and paying
salaries in the functional currency of each of the major countries in which we
do business, thus creating natural hedges. Additionally, as our business matures
in foreign markets, we may offer our products and services in certain other
local currencies. As a result, foreign currency fluctuations would have a
greater impact on our company and may have an adverse effect on our results of
operations. Historically, our gains or losses on foreign currency exchange
translations have been immaterial to our consolidated financial
statements.
 
 19
  We invest
cash balances in excess of operating requirements in short-term securities that
generally have maturities of one year or less. The carrying value of these
securities approximates market value, and there is no long-term interest rate
risk associated with these investments.
  Item 4.
              Controls
      and Procedures.
 
 We
maintain a set of disclosure controls and procedures that are designed to ensure
that information required to be disclosed by us in the reports filed by us under
the Securities Exchange Act of 1934, as amended (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 (principal executive officer) and our
Chief Financial Officer (principal financial officer), of the effectiveness of
the design and operation of our disclosure controls and procedures as of
September 30, 2008 pursuant to Rule 13a-15(b) of the Exchange Act. Based on that
evaluation, our principal executive officer and principal 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 three months ended September 30, 2008 that have materially
affected, or are reasonably likely to materially affect, our internal control
over financial reporting.
 
 PART
II. OTHER INFORMATION
 
 Item 1.
              Legal
      Proceedings.
  The
information set forth in Note 8 of Notes to Condensed Consolidated Financial
Statements included in Part I, Item 1 of this Quarterly Report on Form 10-Q is
incorporated herein by reference.
  Item 1A.
              Risk
      Factors.
 
 In
addition to the information set forth in this Quarterly Report on Form 10-Q and
before deciding to invest in, or retain, shares of our common stock, you also
should carefully review and consider the information contained in our other
reports and periodic filings that we make with the SEC, including, without
limitation, the information contained under the caption Item 1A “Risk Factors”
in our Annual Report on Form 10-K for the year ended December 31, 2007. 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. Except as set forth
below, there have been no material changes from risk factors previously
disclosed in our Annual Report on Form 10-K for the year ended December 31,
2007.
 
 The
Overall Weakened Economic Climate Could Result in Decreased Demand for Our
Products and Services.
 
 Our
products typically represent substantial capital commitments by customers and
involve a potentially long sales cycle. As a result, our operations and
performance depend significantly on worldwide economic conditions and their
impact on customer purchasing decisions.  In this current weakened
economic climate, customers are reviewing the allocation of their capital
spending budgets to communication software, services and systems, which may
result in our customers delaying and/or reducing their capital spending related
to information systems. Some of the factors that could influence the levels of
spending by our customers include continuing increases in energy costs,
availability of credit, labor and healthcare costs, consumer confidence and
other factors affecting spending behavior.  These and other economic
factors could have a material adverse effect on demand for our products and
services and on our financial condition and operating results.
 
 Item
      2.
              Unregistered
      Sales of Equity Securities and Use of
Proceeds.
 
 The
following table presents a summary of the share repurchases we made during the
three months ended September 30, 2008:
 
 Period
              
              Total
      Number of Shares Purchased
              
              
              Average
      Price Paid per Share
              
              
              Total
      Number of Shares Purchased as Part of Publicly Announced Program
      (1)
              
              
              Approximate
      Dollar Value of Shares that May Yet Be Purchased Under the
      ProgramJuly
      1, 2008–July 31, 2008
              
              
              --
              
              
              
              --
              
              
              
              --
              
              
              
              --Aug
      1, 2008–Aug 31,2008
              
              
              70,178
              
              
              $
              9.73
              
              
              
              70,178
              
              
              $
              9,332,289Sept
      1, 2008–Sept 30, 2008
              
              
              283,073
              
              
              
              9.84
              
              
              
              283,073
              
              
              $
              6,559,621Total
              
              
              353,251
              
              
              $
              9.82
              
              
              
              353,251
 (1)
Represents the number of shares repurchased through our repurchase program
authorized by our Board of Directors.
  20
  Item
      6.
              Exhibits.
 
 (a)
              Exhibits
 
 Incorporated
      by ReferenceExhibit
      Number
              
              Exhibit
      Description
              
              Form
              
              Exhibit
              
              Filing
      Date
              
              Filed
      Herewith3.1
              
              Restated
      Articles of Incorporation of the Company, as currently in
      effect
              S-1
                (Registration
      No. 333-79509)
              
              3.1
              
              5/28/19993.2
              
              Amended
      By-Laws of the Company, as currently in effect
              
              8-K
              
              3.2
              
              8/21/200731.1
              
              Certification
      of the Chief Executive Officer pursuant to Rule 13a-14(a)/15d-14(a) of the
      Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the
      Sarbanes-Oxley Act of 2002
              
              
              
              
              
              
              X31.2
              
              Certification
      of the Chief Financial Officer pursuant to Rule 13a-14(a)/15d-14(a) of the
      Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the
      Sarbanes-Oxley Act of 2002
              
              
              
              
              
              
              X32.1
              
              Certification
      of the Chief Executive Officer, pursuant to 18 U. S. C. Section 1350, as
      adopted pursuant to Section 906 of the Sarbanes-Oxley Act of
      2002
              
              
              
              
              
              
              X32.2
              
              Certification
      of the Chief Financial Officer, pursuant to 18 U. S. C. Section 1350, as
      adopted pursuant to Section 906 of the Sarbanes-Oxley Act of
      2002
              
              
              
              
              
              
              X
 
  SIGNATURE
  Pursuant
to the requirements of the Securities Exchange Act of 1934, the registrant has
duly caused this report to be signed on its behalf by the undersigned hereunto
duly authorized.
  Interactive
      Intelligence, Inc.
                (Registrant)Date:   November
      6, 2008
              
              
              
              By:
              
              /s/     Stephen R.
      HeadStephen
      R. Head
                Chief
      Financial Officer,
                Vice
      President of Finance and Administration,
                Secretary
      and Treasurer
                (Principal
      Financial Officer and Principal Accounting
  Officer)
   21