INTERACTIVE INTELLIGENCE INC - 10-Q Quarterly Report

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

	(Mark One)

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

For the quarterly period ended March 31, 2003

Or

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

For the transition period from to

Commission File Number 000-27385

INTERACTIVE INTELLIGENCE, INC.
(Exact name of registrant as specified in its charter)

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

7601 Interactive Way Indianapolis, Indiana 46278
(Address of principal executive offices)

(317) 872-3000
(Registrant’s telephone number)

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

Yes ý No o

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yeso No ý

The number of shares of common stock outstanding on April 30, 2003 was 15,598,947.

TABLE OF CONTENTS

PART I. FINANCIAL INFORMATION

Item 1.	Condensed Consolidated Balance Sheets as of March 31, 2003 and December 31, 2002

	Condensed Consolidated Statements of Operations for the three months ended March 31, 2003 and 2002

	Condensed Consolidated Statements of Cash Flows for the three months ended March 31, 2003 and 2002

	Notes to Condensed Consolidated Financial Statements

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

Item 3.	Quantitative and Qualitative Disclosures About Market Risk

Item 4.	Controls and Procedures

PART II. OTHER INFORMATION

Item 1.	Legal Proceedings

Item 6.	Exhibits and Reports on Form 8-K

SIGNATURES

CERTIFICATIONS

PART I. FINANCIAL INFORMATION

Item 1. Condensed Consolidated Financial Statements and Footnotes.

Interactive Intelligence, Inc.

Condensed Consolidated Balance Sheets

(in thousands, except share amounts)

	March 31, 2003			December 31, 2002
	(Unaudited)
Assets
Current assets:
Cash and cash equivalents	$	12,694		$	5,913
Short-term investments	3,876			9,331
Accounts receivable, net of allowance for doubtful accounts of $402 in 2003 and $671 in 2002	10,876			9,047
Prepaid expenses	2,002			2,170
Other current assets	96			73
Total current assets	29,544			26,534

Property and equipment, net	7,490			7,586

Other assets, net	1,042			1,046
Total assets	$	38,076		$	35,166

Liabilities and shareholders’ equity
Current liabilities:
Accounts payable and accrued liabilities	$	3,334		$	3,203
Accrued compensation and related expenses	1,284			995
Deferred software revenues	11,685			12,102
Deferred services revenues	12,327			9,882
Total current liabilities	28,630			26,182

Shareholders’ equity:
Preferred stock, no par value; 10,000,000 authorized; no shares issued and outstanding	—			—
Common stock, $0.01 par value; 100,000,000 authorized; 15,565,920 issued and outstanding at March 31, 2003, 15,524,369 issued and outstanding at December 31, 2002	156			155
Additional paid-in capital	64,254			64,140
Accumulated other comprehensive income	209			162
Accumulated deficit	(55,173		)	(55,473		)
Total shareholders’ equity	9,446			8,984
Total liabilities and shareholders’ equity	$	38,076		$	35,166

See accompanying notes.

Interactive Intelligence, Inc.

Condensed Consolidated Statements of Operations (unaudited)

(in thousands, except per share amounts)

	Three months ended March 31,
	2003		2002

Revenues:
Software	$	8,621	$	7,592
Services	5,763		4,361
Total revenues	14,384		11,953

Costs and expenses:
Costs of software	292		272
Costs of services	3,186		3,023
Sales and marketing	5,207		5,549
Research and development	3,495		3,906
General and administrative	1,456		1,497
Restructuring charges	448		—
Total costs and expenses	14,084		14,247
Operating income (loss)	300		(2,294		)

Interest income, net	53		129
Income (loss) before income taxes	353		(2,165		)

Income taxes	53		69

Net income (loss)	$	300	$	(2,234	)

Net income (loss) per share:
Basic	$	0.02	$	(0.15	)
Diluted	$	0.02	$	(0.15	)

Shares used to compute net income (loss) per share:
Basic	15,565		15,337
Diluted	15,947		15,337

See accompanying notes.

Interactive Intelligence, Inc.

Condensed Consolidated Statements of Cash Flows (unaudited)

(in thousands)

	Three months ended March 31,
	2003			2002
Operating activities
Net income (loss)	$	300		$	(2,234	)
Adjustments to reconcile net income (loss) to net cash provided (used) by operating activities:
Depreciation	1,278			1,248
Amortization of deferred stock-based compensation	24			23
Changes in operating assets and liabilities:
Accounts receivable	(1,829		)	(685		)
Prepaid expenses	168			38
Other current assets	(23		)	27
Accounts payable and accrued liabilities	131			(371		)
Accrued compensation and related expenses	289			(17		)
Deferred software revenues	(417		)	(1,546		)
Deferred services revenues	2,445			337
Net cash provided (used) by operating activities	2,366			(3,180		)

Investing activities
Purchases of property and equipment, net	(1,182		)	(804		)
Purchases of available-for-sale investments	—			(13,613		)
Sales of available-for-sale investments	5,502			5,373
Change in other assets	4			(28		)
Net cash provided (used) by investing activities	4,324			(9,072		)

Financing activities
Proceeds from issuances of common stock	91			129
Proceeds from stock options exercised	—			38
Net cash provided by financing activities	91			167
Net increase (decrease) in cash and cash equivalents	6,781			(12,085		)

Cash and cash equivalents, beginning of period	5,913			14,503
Cash and cash equivalents, end of period	$	12,694		$	2,418

See accompanying notes.

Interactive Intelligence, Inc

Notes to Condensed Consolidated Financial Statements

(Unaudited)

1. Description of Business and Basis of Presentation

Interactive Intelligence, Inc. (“I3” or the “Company”) is a leading provider of software-based interaction management solutions designed to automate communications for contact centers, enterprises, and service providers. Based on an open, unified platform, the Interactive Intelligence product line was designed as a flexible and affordable alternative to traditional telecom solutions. The Company’s products provide a complete communications solution including PBX (private branch exchange), ACD (automated call distributor), IVR (interactive voice response), unified communications, and Internet and wireless functionality. The Company currently derives substantially all of its revenues from licenses of its Interaction Center Platform products and related services.

Principal operations of the Company commenced during 1997. Since then, the Company has established wholly-owned subsidiaries in Australia, France, the Netherlands and the United Kingdom. The Company also currently has branch offices in Japan, Korea, and Malaysia. The Company’s products are marketed in North America, Central America, South America, Europe, the Asia/Pacific region, Australia, and South Africa.

The accompanying unaudited financial statements have been prepared in conformity with generally accepted accounting principles for interim financial information and with the instructions for Form 10-Q and Article 10 of Regulation S-X. Accordingly, certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed, or omitted, pursuant to the rules and regulations of the Securities and Exchange Commission. In our opinion, the statements include all adjustments necessary (which are of a normal and recurring nature) for the fair presentation of the results of the interim periods presented.

The balance sheet at December 31, 2002 has been derived from the audited financial statements at that date but does not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements.

These financial statements should be read in conjunction with our audited consolidated financial statements for the year ended December 31, 2002, included in the Company’s Form 10-K for the year ended December 31, 2002, filed with the Securities and Exchange Commission on March 31, 2003. Our results of operations for any interim period are not necessarily indicative of the results of operations for any other interim period or for a full fiscal year.

2. Net Income (Loss) Per Common Share

Basic net income (loss) per share is calculated based on the weighted-average number of outstanding common shares. Diluted net income (loss) per share is calculated based on the weighted-average number of outstanding common shares plus the effect of dilutive potential common shares. Potential common shares are composed of shares of common stock of the Company issuable on the exercise of stock options. When potential common shares are dilutive, the treasury stock method is used to compute the common equivalent shares. Under the treasury stock method, the assumed proceeds from the exercise of stock options are applied solely to the repurchase of common stock.

The following table presents the calculation of basic and diluted net income (loss) per share (in thousands, except per share amounts):

	Three Months Ended March 31,
	2003		2002

Net income (loss) (A)	$	300	$	(2,234	)

Weighted average outstanding shares of common stock (B)	15,565		15,337
Dilutive effect of options to purchase common stock	382		—
Common stock and common stock equivalent shares (C)	15,947		15,337

Net income (loss) per share:
Basic (A/B)	$	0.02	$	(0.15	)

Diluted (A/C)	$	0.02	$	(0.15	)

The company’s calculation of diluted net income per share for the three months ended March 31, 2003 excludes 2,374,477 options to purchase common stock with an exercise price ranging from $3.06 to $50.50 as the effect was anitdilutive. For the three months ended March 31, 2002, the Company’s calculation of diluted net loss per share excludes all potential common shares as the effect would be antidilutive. Options to purchase 3,305,794 shares of common stock with exercise prices of $0.13 to $50.50 per share were outstanding as of March 31, 2002.

3. Shareholders’ Equity

The Company accounts for its stock option plans in accordance with Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation (“SFAS 123”) and uses the intrinsic value method consistent with the existing rules established by APB Opinion No. 25, Accounting for Stock Issued to Employees, and related Interpretations. The majority of options granted to employees under these plans had an exercise price equal to the market value of the underlying common stock on the date of grant. The table included below illustrates the effect on the net income (loss) and earnings (loss) per share if the Company had applied the fair value recognition provisions of SFAS 123 to stock-based employee compensation.

(in thousands except per share amounts):

	Three Months Ended March 31,
	2003			2002
Net income (loss), as reported	$	300		$	(2,234	)
Deduct: Total stock-based compensation expense determined under fair value based method for all awards, net of related tax effects	(1,389		)	(1,467		)

Pro forma net loss	$	(1,089	)	$	(3,701	)

Income (loss) per share:
Basic - as reported	$	0.02		$	(0.15	)
Diluted - as reported	$	0.02		$	(0.15	)

Basic - pro forma	$	(0.07	)	$	(0.24	)
Diluted - pro forma	$	(0.07	)	$	(0.24	)

4. Concentration of Credit Risk

One customer represented approximately 16% of total revenues and 29% of accounts receivable for the three months ended March 31, 2003.

5. Contingencies

In June 1999 and September 1999, the Company received letters from a competitor in the call center market claiming that the Company’s products utilize technologies pioneered and patented by that competitor. The Company’s patent counsel has reviewed all of the patents listed in the letters. Based on the advice of the Company’s patent counsel, the Company believes that its products do not infringe any of the patents listed in either letter. The Company has discussed its conclusion with the competitor and has also discussed possible licensing of certain technologies from the competitor. Although the Company has not heard from this competitor since early 2001, the Company cannot assure you that this matter can be resolved amicably without litigation, or that it will ultimately be able to enter into a licensing arrangement on terms and conditions that would not have a material adverse effect on the Company’s business, financial condition or results of operations.

In June 2000 and October 2001, the Company received letters from a competitor in the outbound call center market claiming that the Company’s products utilize technologies pioneered and patented by the competitor. Although the Company’s patent counsel has not determined the validity of these patents, the Company has discussed the possible licensing of certain technologies from the competitor. Ownership of the technology has changed once since the original letters, and the technology and related business unit are being marketed for sale by their current owner, who has filed for bankruptcy protection. The Company cannot assure you that these claims can be resolved amicably without litigation, or that it will be able to enter into licensing arrangements on terms and conditions that would not have a material adverse effect on the Company’s business, financial condition or results of operations.

In July 2002, the Company received a letter from a consulting firm which has been retained by a telecommunication technology provider to develop and implement a licensing program based on

the technology provider’s patents. The consulting firm believes a licensing agreement between the Company and the technology provider is appropriate. The Company’s patent counsel is in the process of reviewing the patents listed in the letter. To date, the Company’s patent counsel has not determined the validity or applicability of these patents. The Company cannot assure you that this matter can be resolved amicably without litigation, or that it will be able to enter into a licensing arrangement on terms and conditions that would not have a material adverse effect on the Company’s business, financial condition or results of operations.

In December 2002, the Company received a letter from one of its resellers requesting indemnification related to a request that it had received for indemnification from an end user that had received a letter from a third party indicating that the end user may be infringing patents held by the third party. To date, the Company’s patent counsel has not determined the validity or the applicability of these patents as they relate to the Company’s products or whether the reseller is entitled to indemnification. The Company cannot assure you that this claim for indemnification can be resolved favorably in a manner that would not have a material adverse effect on the Company’s business, financial condition or results of operations.

Other third parties could claim that our technology infringes their proprietary rights. Infringement claims, even if without merit, can be time consuming and expensive to defend. A third party asserting infringement claims against us or our customers with respect to our current or future products may require us to enter into costly royalty arrangements or litigation, or otherwise materially adversely affect us.

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. This assessment claims various taxes are owed related to Value Added Tax (“VAT”) and corporation taxes in addition to what has previously been paid and accrued. The assessment related to VAT is approximately 2.3 million Euros or approximately $2.5 million as of March 31, 2003 and the assessment related to corporation taxes is approximately 300,000 Euros or approximately $330,000 as of March 31, 2003. Based primarily on advice from the Company’s tax counsel, the Company currently believes the possibility of the Company paying the assessment related to VAT to be remote and the assessment related to corporation taxes to be reasonably possible. The Company is appealing the assessment, but cannot assure you this matter will be resolved without litigation, that it will not take several years to resolve, or that the Company will not have to pay some or all of the assessment. Currently, the Company has accrued approximately $97,000 related to the tax assessment.

From time to time, the Company is also involved in certain legal proceedings in the ordinary course of conducting our 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 the Company’s financial position.

6. Restructuring and Other Charges

In February 2003, the Company announced its plan to downsize and reorganize resources in the Europe, Middle East, and Africa (“EMEA”) region. Of the 20 positions located in France, six positions were transferred to other EMEA offices, four will remain in France, and 10 were eliminated. The reorganization affected all departments in EMEA. For the three months ended March 31, 2003, a total of $448,000 was recognized in accordance with Statement of Financial Accounting Standards No. 146, Accounting for Costs Associated with Exit or Disposal Activities (“SFAS 146”) as restructuring charges. Of the total amount, approximately $333,000 was related to severance and the remaining amount was related to professional fees.

The Company anticipates additional restructuring charges to be incurred in the second quarter as the reorganization is expected to be substantially completed by June 30, 2003. The restructuring charges will be related to additional severance , professional fees and to the facilities which are

currently being leased. The Company anticipates the charge in the second quarter related to the EMEA reorganization to range from $900,000 to approximately $1.2 million.

Additional charges will be incurred in the second quarter 2003 related to unused leased facilities in the North American region up to approximately $1.7 million.

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

Forward-Looking Information

Certain statements in this Form 10-Q contain “forward-looking” information (as defined in Section 27A of the Securities Act of 1933, as amended and Section 21E of the Securities Exchange Act of 1934, as amended) that involve risks and uncertainties which may cause actual results to differ materially from those predicted in the forward-looking statements. Forward-looking statements can be identified by their use of such verbs as “expects,” “anticipates,” and “believes” or similar verbs or conjugations of such verbs. If any of our assumptions on which the statements are based prove incorrect or should unanticipated circumstances arise, our actual results could materially differ from those anticipated by such forward-looking statements. The differences could be caused by a number of factors or combination of factors, including, but not limited to, the “Factors Affecting Operating Results” described herein and the Risk Factors described in our Securities and Exchange Commission filings, including the Form 10-K filing for the year ended December 31, 2002.

Overview

We commenced operations in October 1994. Through the end of 1996, we focused primarily on research and development activities. Our first product was released in March 1997. In 1997 and 1998, we expanded our operations to capitalize on the increased market demand for communications and interaction management software. We decided, at the expense of profitability, to continue investing significantly in research and development, and to accelerate our investments in marketing, services and sales operations. We had no revenue in 1996, and our total revenues were $1.6 million in 1997, $9.0 million in 1998, $19.1 million in 1999, $27.3 million in 2000, $47.9 million in 2001, and $47.8 million in 2002. We cannot assure you that our revenues will grow in the future.

We believe our investments in research and development and in marketing, services and sales operations will continue to be critical to any revenue growth we achieve. However, these investments have also significantly increased our operating costs and expenses, contributing to the net losses and operating losses that we have incurred in all but our last fiscal quarter since our formation. In addition, we are likely to continue to experience losses and negative cash flows from operations in future quarters. We cannot assure you when or if we will achieve profitability again or, if achieved, that we will be able to sustain profitability. Our operating results have varied significantly from quarter to quarter and may continue to do so in the future. As a result, we believe that period-to-period comparisons of our operating results are not necessarily meaningful, and you should not rely on them as an indication of our future performance.

As of March 31, 2003 we incurred approximately $448,000 in restructuring charges related to the restructuring of our EMEA organization which was announced in February 2003. These charges related primarily to severance and professional services.

Critical Accounting Policies and Estimates

We believe the accounting policies that are related to revenue recognition and the allowance for doubtful accounts receivable are important to understanding our performance. These policies, which involve significant management judgment and estimates, and related procedures are described in detail below.

Sources of Revenues and Revenue Recognition Policy

The Company generates software revenues from licensing the right to use its software products and generates services revenues from annual license fees, ongoing maintenance (post-contract technical support and unspecified product upgrades), educational services, and professional services.

Our software license fees primarily originate from the marketing efforts of our resellers, who are authorized to place orders for software licenses with us on behalf of end-user customers. We share end-user customer software license fees with these resellers in varying percentages of our list price, according to the terms of their reseller agreements. In addition to generating software license fees indirectly through resellers, we also receive some software license fees from end-user customers that we contract with directly. Our software license agreements are either annually renewable or perpetual.

For any revenues to be recognized from a software license agreement, the following criteria must be met:

• persuasive evidence of an arrangement exists;

• the fee is fixed or determinable;

• collection is probable; and

• delivery has occurred.

Delivery is further defined in certain software license agreements as delivery of the product master or first copy for non-cancelable product licensing arrangements under which the recipient, typically a reseller, has certain software distribution rights. For these licensing arrangements, the delivery criteria has been met when a binding order for a specified end-user customer is placed, as the reseller already possesses a product master copy and the Company has no further delivery obligations.

Under our annually renewable license agreements, the initial reseller order or end-user contract includes both an initial license fee and an annual license fee. Upon meeting the revenue recognition criteria, we recognize the initial license fees under these annually renewable license agreements as software revenues ratably over the initial license period, which is generally twelve months. Under our annually renewable license agreements, we also recognize annual license fees as services revenues ratably over the term of the initial license period, which is generally twelve months. After the initial license period, our end-user customers may renew their license agreement for an additional annual period by paying an additional annual license fee. We recognize these additional annual license fees as services revenues ratably over the term of the renewal period, which is also generally twelve months. If the annual license fee is not paid, the customer is no longer entitled to use the software and we may terminate its license agreement. Payment of the annual license fee also entitles the customer to ongoing maintenance (post-contract technical support and unspecified product upgrades) for the renewal period.

Under our perpetual license agreements, the initial reseller order or end-user contract includes both an initial license fee and an annual maintenance fee. Upon meeting the revenue recognition criteria, we immediately recognize the entire amount of initial license fees under these perpetual license agreements as software revenues if sufficient vendor specific objective evidence exists to support allocating the total fee to all elements of the arrangement. If sufficient vendor specific objective evidence does not exist, we typically recognize the initial license fee ratably over the initial term of the license agreement, which is generally twelve months.

Under our perpetual license agreements, we also recognize annual maintenance fees as services revenues ratably over the post-contract maintenance period, which is typically twelve months. Our end-user customers may renew their maintenance term for an additional one-year period by paying an additional maintenance fee. We recognize these additional maintenance fees as services revenues ratably over the term of the renewal period, which is also generally twelve months. Payment of the annual maintenance fee entitles the customer to ongoing maintenance (post-contract technical support and unspecified product upgrades).

We share annual license fees and ongoing maintenance fees with those resellers who provide initial technical support to end-user customers according to the terms of their reseller agreements. When these revenues are shared with resellers, we typically receive between 50% and 70% of the amount charged to the end-user customer.

We also generate revenues from other services that we provide to our resellers and end-user customers. In addition to annual license fees and ongoing maintenance fees, services revenues include educational services and professional services. Revenues from educational services, which consist of training courses for resellers and end-user customers, and professional services, which include implementing and customizing our products for an end-user customer, are typically recognized as the related services are performed.

Allowance for Doubtful Accounts for Accounts Receivable

We record our allowance for doubtful accounts for each reporting period based on a detailed analysis of our accounts receivable at the end of that period. In estimating the allowance for doubtful accounts, we primarily consider the age of the customer’s accounts receivable and also consider the creditworthiness of the customer, the economic conditions of the customer’s industry, and general economic conditions, among other factors. Should any of these factors change, the estimates made by us will also change, which could impact the level of our future allowance for doubtful accounts. Specifically, if the financial condition of our customers were to deteriorate, affecting their ability to make payments, increases to allowances for doubtful accounts may be required.

Historical Results of Operations

The following table presents certain financial data, derived from our unaudited statements of operations, as a percentage of total revenues for the periods indicated. The operating results for the three months ended March 31, 2003 and 2002 are not necessarily indicative of the results that may be expected for the full year or for any future period.

	Three months ended March 31,
	2003		2002
Revenues:
Software	60	%	64	%
Services	40		36
Total revenues	100		100

Costs and expenses:
Costs of software	2		2
Costs of services	22		25
Sales and marketing	36		46
Research and development	24		33
General and administrative	10		13
Restructuring charges	3		—
Total costs and expenses	97		119

Operating income (loss)	3		(19	)
Interest income, net	0		1
Income (loss) before income taxes	3		(18	)
Income taxes	0		1
Net income (loss)	3	%	(19	)%

Revenues

Our total revenues increased 20% from $12.0 million for the three months ended March 31, 2002 to $14.4 million for the three months ended March 31, 2003. Non-North American revenues decreased slightly from $2.3 million for the three months ended March 31, 2002 to $2.1 million for the three months ended March 31, 2003. Our revenues are derived from software license fees and charges for services, including annual license fees and ongoing maintenance fees, education services, and professional services. The increase in total revenues resulted from higher software revenues, including a perpetual license agreement with one customer which comprised approximately 16% of total revenues, and higher services revenues mainly related to annual license and ongoing maintenance fees from our growing customer base.

Software. Our software revenues increased 14% from $7.6 million for the three months ended March 31, 2002, to $8.6 million for the three months ended March 31, 2003. The increase in software revenues included a perpetual license agreement with one customer, which accounted for 27% of software revenues. Because this license agreement was perpetual and met all revenue recognition criteria, all software revenue related to this license agreement was recognized immediately.

While we experienced growth of our software revenues for the three months ended March 31, 2003, we continue to expect the remainder of 2003 to be a challenging sales environment for capital investments. Factors that could impact our software revenues and deferred software revenues in 2003 compared to 2002 include whether we can increase the amount of our enterprise product licenses (e.g., Communité™ and Enterprise Interaction Center®), the license mix of perpetual compared to annually renewable licenses, and seasonality, which is typically weighted toward the end of a calendar year.

Services. Services revenues increased 32% from $4.4 million for the three months ended March 31, 2002, to $5.8 million for the three months ended March 31, 2003. The increase in services revenues was

primarily due to an increase in annual license fees and ongoing maintenance fees, both of which are related to our growing installed base of end-user customers. To a lesser extent, we also saw growth in revenues from professional services. As we add more customers and focus on servicing our existing customer base, we believe our services revenues will continue to grow.

Cost and Expenses

Our total costs and expenses decreased 1% from $14.2 million for the three months ended March 31, 2002 to $14.1 million for the three months ended March 31, 2003. The decrease in amount was primarily due to the results following the implementation of our restructuring plans to reduce expenses beginning in April 2002 and February 2003, as well as increased operating efficiencies, offset by higher variable costs primarily related to higher software revenues.

Costs of Software. Costs of software consist primarily of product royalties paid to third-parties for the use of their technologies in our products and, to a lesser extent, software packaging costs, which include product media, duplication and documentation. Costs of software increased from $272,000 for the three months ended March 31, 2002 to $292,000 for the three months ended March 31, 2003. This represents approximately 4% of software revenues for the three months ended March 31, 2002 and 3% for the three months ended March 31, 2003. The slight dollar increase was primarily attributable to the increase in software revenues. We currently expect product royalties to continue to increase as we release additional products, release additional versions of our existing products, and integrate additional third-party software functions and features into our product offerings.

Costs of Services. Costs of services consist primarily of compensation expenses for technical support, education, and professional services personnel and other costs associated with supporting our resellers and end-user customers. Costs of services increased from $3.0 million for the three months ended March 31, 2002, to $3.2 million for the three months ended March 31, 2003. As a percentage of services revenues, cost of services represented 69% and 55% for the three months ended March 31, 2002 and 2003, respectively. The dollar increase is a result of increased services revenues and the need to continue to support the growing customer base. The decrease of cost of services as a percent of services sales is related to continued operating efficiencies being realized by our support, education, and professional services resources as our customer base grows. While we anticipate that costs of services will increase as we add more customers and service our existing customer base, we also currently believe there is a continued opportunity for costs of services to continue to slightly decline as a percentage of services revenues.

Sales and Marketing. Sales and marketing expenses primarily consist of compensation expenses (including sales commissions), travel expenses, trade shows, telemarketing campaigns, public relations and other promotional expenses. Sales and marketing expenses decreased from $5.5 million for the three months ended March 31, 2002 to $5.2 million for the three months ended March 31, 2003. The decrease was primarily the result of reduced compensation and discretionary marketing expenditures following the implementation of our 2002 restructuring plans, somewhat offset by higher variable compensation expenses associated with higher software revenues. We continue to expect sales and marketing expense to be essentially flat in 2003 from 2002, although we will add sales and marketing personnel and increase sales and marketing efforts if performance dictates and/or attractive opportunities present themselves in the remainder of 2003.

Research and Development. Research and development expenses consist primarily of compensation expenses for our developers and, to a lesser extent, and third party efforts to develop new products and enhance existing products, including adapting our products for specific non-English languages and allowing our products to effectively run with alternative hardware configurations. Research and development expenses decreased from $3.9 million for the three months ended March 31, 2002 to $3.5 million for the three months ended March 31, 2003. The decrease is a result of the implementation of our 2002 and 2003 restructuring plans. Currently, all costs related to research and development of our products are charged to research and development expense as incurred.

General and Administrative. General and administrative expenses consist primarily of compensation for our administrative, financial, and information technology personnel, and a number of non-allocable costs, including bad debt, legal and other professional service fees. General and administrative expenses remained constant at $1.5 million for the three months ended March 31, 2002 and March 31, 2003. We continue to believe our general and administrative expenses will be slightly higher in the remainder of 2003 over 2002 due to increased costs from our new headquarters building.

Restructuring Charges. For the three months ended March 31, 2003, we incurred $448,000 in restructuring charges related to our resource reorganization in the EMEA region. In February 2003, the Company announced its plan to downsize and reorganize resources in the EMEA region. Of the 20 positions located in France, six positions were transferred to other EMEA offices, four positions remained in France, and 10 positions were eliminated. The reorganization affected all departments in EMEA. Of the total restructuring charges recognized, approximately $333,000 was related to severance and the remaining amount was related to professional fees. The Company anticipates additional restructuring charges related to the EMEA region reorganization to be incurred in the second quarter of 2003, as we expect to be substantially complete with the reorganization by June 30, 2003. The restructuring charges are expected to range from $900,000 to $1.2 million and will be related to additional severance, related professional fees and to the facilities which are currently being leased.

Additional other charges will be incurred in the second quarter 2003 related to unused leased facilities in the North American region as further discussed below in Liquidity and Capital Resources.

Interest income, net

Interest income, net decreased from $129,000 for the three months ended March 31, 2002 to $53,000 for the three months ended March 31, 2003. This decrease resulted from the substantial decrease in interest rates and less invested cash.

Income taxes

For U.S. corporate income tax purposes, we did not recognize a tax benefit related to U.S. federal or state income taxes during the three months ended March 31, 2002 or March 31, 2003 because of the uncertainty of eventually realizing the benefits of our operating losses. However, we did recognize a tax expense related to our international operations of $69,000 for the three months ended March 31, 2002, and $53,000 for the three months ended March 31, 2003.

As described in Note 5 of our Notes to the Condensed Consolidated Financial Statements, we have 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. The total assessment is approximately 2.6 million Euros or approximately $2.7 million. We are appealing the assessment, but cannot assure you that this matter will be resolved without litigation, that it will not take several years to resolve or that we will not have to pay some or all of the assessment.

Liquidity and Capital Resources

As of March 31, 2003, we had cash and cash equivalents of $12.7 million, $3.9 million in short term investments and a working capital balance of $914,000.

As of March 31, 2003, we had one customer that represented 29% of our total accounts receivable balance. The payment terms related to this transaction are one-third due by April 30, 2003, one-third due by May 30, 2003 and one-third due by June 30, 2003. We have received the first installment timely.

Our operating activities resulted in a net cash inflow of $2.4 million for the three month period ended March 31, 2003, and a net cash outflow of $3.2 million for the three month period ended March 31, 2002. The net operating cash inflow for the first three months of 2003 was primarily the result of our net income, non-cash depreciation amount, and an increase in deferred services revenue, partially offset by an increase in accounts receivable. The net operating cash outflow for the first three months of 2002 was primarily the

result of our operating loss, a decrease in deferred software revenues, and an increase in accounts receivable, partially offset by the non-cash depreciation amount.

Our investing activities have consisted primarily of capital expenditures for property and equipment and purchases and sales of investments. Our activities resulted in a $4.3 million inflow for the three month period ended March 31, 2003 and a $9.1 million outflow for the three month period ended March 31, 2002. The inflow for the first three months of 2003 was attributed to the net sale of available-for-sale investments, partially offset by capital expenditures for property and equipment. The net outflow for the first three months of 2002 was attributable to net purchases of available-for-sale investments and capital expenditures for property and equipment. At March 31, 2003, other than approximately $440,000 in primarily leasehold improvements related to the completion of our new corporate headquarters building, we did not have any material commitments for future capital expenditures.

In April 2001, we entered into a non-cancelable lease agreement for a new, approximately 120,000 square foot corporate headquarters building that we moved into in April 2003. Over the life of the lease, 15 years, we are committed to expend approximately $35.1 million in rent payments.

As of April 2003, we had approximately 78,000 square feet of unused office facilities related to our prior headquarters and associated facilities which we continue to market for sublease. As the overall sublease market is difficult and we have less than one year left on the substantial majority of these leases, we believe it is not probable that our sublease efforts will be successful. The remaining rent obligation on the unused space is approximately $1.5 million as of April 2003, and there are approximately $220,000 of leasehold improvements related to this unused space which will no longer be useful. We expect to incur a charge related to both the unused facilities and unused leasehold improvements in the second quarter of 2003 up to $1.7 million.

For the three months period ended March 31, 2003 we generated $91,000 from financing activities attributed to the issuance of common stock. For the three months ended March 31, 2002 we generated $167,000 related to the issuance of common stock and stock option exercises.

We believe that our existing cash and cash equivalents and short-term investments will be sufficient to meet our working capital and capital expenditure requirements for at least the next 12 months. After that time, we may require additional funds to support our working capital requirements or for other corporate purposes, and we may seek to raise additional funds through public or private equity or debt financings or from other sources. We cannot assure you that additional financing will be available at all or that, if available, it will be on terms favorable to us or that any additional financing will not dilute your ownership interest in the Company.

Factors that may affect our future operating results are set forth below:

THE OVERALL ECONOMIC CLIMATE CONTINUES TO BE WEAK

Our products typically represent substantial capital commitments by customers, involving a potentially long sales cycle. As a result, customer purchase decisions may be significantly affected by a variety of factors, including general economic trends in the allocation of capital spending budgets for communication software, services and systems, lengthened sales cycles, customer approval processes, and market conditions, which have resulted in many of our customers delaying and/or reducing their capital spending related to information systems. If the economy continues to be weak, demand for our products could decrease, resulting in lower revenues.

WE HAVE HISTORICALLY INCURRED LOSSES AND WE MAY NOT SUSTAIN PROFITABILITY

Since inception, the first quarter of 2003 is the only quarter we have been profitable. We incurred net losses of $7.7 million, $11.0 million, and $15.1 million in 2002, 2001, and 2000, respectively. At March 31, 2003, we had accumulated net losses since inception of $55.2 million. We intend to continue to make

significant investments in our research and development, marketing, services and sales operations. We anticipate that these expenses could significantly precede any revenues generated by the increased spending. As a result, we are likely to continue to experience losses and negative cash flow from operations in future quarters.

OUR QUARTERLY OPERATING RESULTS HAVE VARIED SIGNIFICANTLY AND, IF SEVERAL FACTORS AFFECTING OUR BUSINESS CAUSE THEM TO CONTINUE TO DO SO, THE MARKET PRICE OF OUR COMMON STOCK COULD BE AFFECTED

Our operating results have varied significantly from quarter to quarter and may continue to do so in the future depending on a number of factors affecting us or our industry, including many that are beyond our control. As a result, we believe that period-to-period comparisons of our operating results are not necessarily meaningful, and you should not rely on them as an indication of our future performance. In addition, our operating results in a future quarter or quarters may fall below expectations of securities analysts or investors and, as a result, the price of our common stock may fluctuate.

Because we do not know if or when our potential end-user customers will place orders and finalize licenses, and it is difficult to predict the mix of annually renewable licenses and perpetual licenses in a quarter, we cannot accurately forecast our licensing activity, our revenues and our operating results for future quarters. We recognize revenues from different licenses over different periods on satisfaction of the requirements of AICPA Statement of Position 97-2, Statement of Position 97-2, and all related AICPA Technical Practice Aids (5100.38 - 5100.76). As a result, our quarterly revenues and operating results depend on many factors, including the type of license, and the size, quantity and timing of orders received for our products during each quarter. If a large number of orders or several large orders do not occur or are deferred or delayed, our revenues in a quarter could be substantially reduced. This risk is heightened by the significant investment and executive level decision-making typically involved in our end-user customers’ decisions to license our products. Since a large portion of our operating expenses, including rent and salaries, is fixed and difficult to reduce or modify, our business, financial condition or results of operations could be materially adversely affected if revenues do not meet our expectations.

Because of our limited number of products, changes in pricing policies and the timing of the development, announcement and sale of new or upgraded versions of our products are some of the additional factors that could cause our revenues and operating results to vary significantly from quarter to quarter.

WE HAVE A LENGTHY PRODUCT SALES CYCLE, WHICH HAS CONTRIBUTED, AND MAY CONTINUE TO CONTRIBUTE, TO THE QUARTER-TO-QUARTER VARIABILITY OF OUR REVENUES AND OPERATING RESULTS, WHICH COULD AFFECT THE MARKET PRICE OF OUR COMMON STOCK

We have generally experienced a lengthy product sales cycle, averaging approximately six to nine months. The lengthy sales cycle is one of the factors that has caused, and may in the future continue to cause, our software revenues and operating results to vary significantly from quarter to quarter, which could affect the market price of our common stock. It also makes it difficult for us to forecast product license revenues. Because of the unique characteristics of our products, our prospective end-user customers’ decisions to license our products often require significant investment and executive level decision making. We believe that many companies currently are not aware of the benefits of interaction management software of the type we license or of our products and capabilities. For this reason, we must provide a significant level of education to prospective end-user customers about the use and benefits of our products, which can cause potential end-user customers to take many months to make these decisions. As a result, sales cycles for end-user customer orders vary substantially from customer to customer. Excessive delay in product sales could materially adversely affect our business, financial condition or results of operations.

The length of the sales cycle for end-user customer orders depends on a number of other factors over which we have little or no control, including:

• an end-user customer’s budgetary constraints;

• the timing of an end-user customer’s budget cycles;

• concerns by end-user customers about the introduction of new products by us or our competitors; and

• downturns in general economic conditions, including reductions in demand for call center services.

In addition, the sales cycle for our products in international markets has been, and is expected to continue to be, longer than the sales cycle in the United States. The average sales cycle for our products may lengthen as we expand internationally.

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

As the complexity of our product technology and our reseller and other third-party relationships have increased, the management of those relationships and the negotiation of contractual terms sufficient to protect our rights and limit our potential liabilities has become more complicated, and we expect this trend to continue in the future. As a result, our inability to successfully manage these relationships or negotiate sufficient contractual terms could have a material adverse effect on us.

WE FACE COMPETITIVE PRESSURES, WHICH MAY HAVE A MATERIAL ADVERSE EFFECT ON US

The market for our software products is highly competitive and, because there are relatively low barriers to entry in the software market, we expect competition to increase significantly in the future. In addition, because our industry is new and evolving and characterized by rapid technological change, it is difficult for us to predict whether, when and by whom new competing technologies or new competitors may be introduced into our markets. Currently, our competition comes from several different market segments, including computer telephony platform developers, computer telephony applications software developers and telecommunications equipment vendors. We cannot assure you that we will be able to compete effectively against current and future competitors. In addition, increased competition or other competitive pressures may result in price reductions, reduced margins or loss of market share, any of which could have a material adverse effect on our business, financial condition or results of operations.

Many of our current and potential competitors have longer operating histories, significantly greater financial, technical, marketing, customer service and other resources, greater name recognition and a larger installed base of customers than we do. As a result, these competitors may be able to respond to new or emerging technologies and changes in customer requirements faster and more effectively than we can, or to devote greater resources to the development, promotion and sale of products than we can. Current and potential competitors have established, and may in the future establish, cooperative relationships among themselves or with third parties, including mergers or acquisitions, to increase the ability of their products to address the needs of our current or prospective end-user customers. If these competitors were to acquire significant market share, it could have a material adverse effect on our business, financial condition or results of operations.

WE MAY NOT BE ABLE TO GROW OUR BUSINESS IF WE DO NOT MAINTAIN SUCCESSFUL RELATIONSHIPS WITH OUR RESELLERS AND OEM PARTNERS AND CONTINUE TO RECRUIT AND DEVELOP ADDITIONAL SUCCESSFUL RESELLERS AND OEM PARTNERS

Our ability to achieve revenue growth in the future will depend in part on our success in maintaining successful relationships with our existing and future resellers and OEM partners and in recruiting and training additional resellers and OEM partners. We rely primarily on resellers to market and support our products and plan on continuing to rely heavily on such partners in the future. We are still developing and improving our reseller and OEM distribution networks and may be unable to attract additional resellers

with both voice and data expertise or appropriate OEM partners that will be able to market our products effectively and that will be qualified to provide timely and cost-effective customer support and service. We generally do not have long-term or exclusive agreements with our resellers or OEM partners, and the loss of specific larger resellers or OEM partners or a significant number of resellers or OEM partners could materially adversely affect our business, financial condition or results of operations.

OUR MARKETS ARE CHARACTERIZED BY RAPID TECHNOLOGICAL CHANGE WHICH MAY CAUSE US TO INCUR SIGNIFICANT DEVELOPMENT COSTS AND PREVENT US FROM ATTRACTING NEW CUSTOMERS

The market for our products is characterized by rapid technological change, frequent new product introductions and enhancements, uncertain product life cycles and changing end-user customer demands. The introduction of products embodying new technologies and the emergence of new industry standards could render existing products obsolete or unmarketable and cause us to incur significant development costs.

THE GROWTH OF OUR BUSINESS MAY BE IMPEDED WITHOUT INCREASED USE OF THE INTERNET

The use of the Internet as a commercial marketplace is at an early stage of development. Demand and market acceptance for recently introduced products and services available over the Internet are still uncertain. In addition, governmental regulation of the Internet, such as imposing sales and other taxes, access charges, and pricing controls and inhibiting cross-border commerce, may reduce the use of the Internet by businesses for their electronic commerce and customer service needs. To date, governmental regulations have not materially restricted commercial use of the Internet. However, the legal and regulatory environment that pertains to the Internet is uncertain and may change. New regulations could reduce the use of the Internet by our end-user customers and, in turn, their customers. The lack of acceptance of the Internet as a forum for conducting business could reduce growth in demand for our products and limit the growth of our revenues.

OUR BUSINESS WILL BE ADVERSELY AFFECTED IF WEB-BASED ELECTRONIC BUSINESS SOLUTIONS ARE NOT WIDELY UTILIZED

Our products address a market for Web-based, interactive electronic business solutions. Therefore, our future success depends on the widespread adoption of the Web as a primary medium for commerce and business applications. The failure of this market to expand, or a delay in the development of this market, could have a material adverse effect on our business, financial condition or results of operations. The Web has experienced, and is expected to continue to experience, significant user and traffic growth, which has, at times, caused user frustration with slow access and download times. The Web infrastructure may not be able to support the demands placed on it by the continued growth on which our success depends. Moreover, critical issues concerning the commercial use of the Web, such as security, reliability, cost, accessibility and quality of service, remain unresolved and may negatively affect the growth of Web use or the attractiveness of commerce and business communication over the Web. In addition, the Web could lose its viability due to delays in the development or adoption of new standards and protocols to handle increased activity or due to increased government regulation and taxation of Internet commerce.

A DECLINE IN MARKET ACCEPTANCE FOR MICROSOFT CORPORATION TECHNOLOGIES ON WHICH OUR PRODUCTS RELY COULD HAVE A MATERIAL ADVERSE EFFECT ON US

Our products currently run only on Microsoft Windows operating systems. In addition, our products use other Microsoft Corporation technologies, including Microsoft Exchange Server® and Microsoft SQL Server®. A decline in market acceptance for Microsoft technologies or the increased acceptance of other server technologies could cause us to incur significant development costs and could have a material adverse effect on our ability to market our current products. Although we believe that Microsoft technologies will continue to be widely used by businesses, we cannot assure you that businesses will adopt these technologies as anticipated or will not in the future migrate to other computing technologies that we do not

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

OUR FUTURE BUSINESS PROSPECTS DEPEND IN PART ON OUR ABILITY TO MAINTAIN AND IMPROVE OUR CURRENT PRODUCTS AND DEVELOP NEW PRODUCTS

We believe that our future business prospects depend in large part on our ability to maintain and improve our current products and to develop new products on a timely basis. Our products will have to achieve market acceptance, maintain technological competitiveness and meet an expanding range of end-user customer requirements. As a result of the complexities inherent in our products, major new products and product enhancements require long development and testing periods. We may not be successful in developing and marketing, on a timely and cost effective basis, product enhancements or new products that respond to technological change, evolving industry standards or end-user customer requirements. We may also experience difficulties that could delay or prevent the successful development, introduction or marketing of product enhancements, and our new products and product enhancements may not achieve market acceptance. Significant delays in the general availability of new releases of our products or significant problems in the installation or implementation of new releases of our products could have a material adverse effect on our business, financial condition or results of operations.

SLOW GROWTH, OR A DECLINE IN DEMAND FOR INTERACTION MANAGEMENT SOFTWARE OF THE TYPE WE LICENSE, COULD MATERIALLY ADVERSELY AFFECT OUR FINANCIAL RESULTS AND GROWTH PROSPECTS

If the demand for interaction management software of the type we license does not grow within each of our three targeted markets, our financial results and ability to grow our business could be materially adversely affected. All of our revenues have been generated from licenses of our Interaction Center Platform® software or complementary products, and related support, educational and professional services. We expect these products and services to account for the majority of our revenues for the foreseeable future. Although we believe demand for the functions performed by our products is high, the market for our products and services is still emerging. Further, our growth plans require us to successfully attract enterprise and service provider end-user customers in significantly larger numbers than we have historically achieved.

IF OUR END-USER CUSTOMERS DO NOT PERCEIVE OUR PRODUCTS OR THE RELATED SERVICES PROVIDED BY US OR OUR RESELLERS OR OEM PARTNERS TO BE EFFECTIVE OR OF HIGH QUALITY, OUR BRAND AND NAME RECOGNITION WILL SUFFER

We believe that establishing and maintaining brand and name recognition is critical for attracting, retaining and expanding end-user customers in our target markets. We also believe that the importance of reputation and name recognition will increase as competition in our market increases. Promotion and enhancement of our name will depend on the effectiveness of our marketing and advertising efforts and on our success in providing high-quality products and related services, neither of which can be assured. If our end-user customers do not perceive our products or related services to be effective or of high quality, our brand and name recognition would suffer which could have a material adverse effect on our business, financial condition or results of operations.

OUR SERVICES REVENUES ARE DEPENDENT ON OUR INSTALLED BASE OF CUSTOMERS

We have depended and will continue to depend on our installed customer base for additional future revenues from services, including annual license fees and ongoing maintenance fees. There can be no assurance that current installed customers will renew their licenses or pay ongoing maintenance fees in future periods. As a consequence, our operating results, cash flows and liquidity would likely be adversely affected. Our failure to obtain new customers or additional orders form existing customers could also materially affect our operating results.

ANY DECREASE IN OUR LICENSING ACTIVITY IS LIKELY TO RESULT IN REDUCED SERVICES REVENUES IN FUTURE PERIODS

Our services revenues are generated primarily from annual license fees, ongoing maintenance (post-contract technical support and unspecified product upgrades), educational services, and professional services. A decrease in our services revenues could follow a decrease in our licenses revenues. Our ability to maintain or increase our services revenues depends in large part on our ability to increase our software licensing activity.

IF WE ARE UNABLE TO ADAPT OUR SOFTWARE IN A WAY THAT WILL PERMIT US TO SERVE LARGE, SINGLE-SITE END-USER CUSTOMERS, THE MARKETABILITY OF OUR PRODUCTS COULD BE ADVERSELY AFFECTED

Our products cannot currently meet the communications needs of organizations with more than 500 users at a single call center location. As these organizations expand to include multiple locations, our products can be customized to increase the number of telephone lines, extensions and users. We will need to adapt our software to serve larger single-site organizations. Although we are currently developing and testing solutions that would enable our software to significantly increase the number of users that our products can serve at a single location, we cannot assure you that we will be able to successfully introduce this technology into a currently available version of our products. Further, we may not be able to adapt our software in a timely or cost effective manner in a way that will permit us to serve these customers. This inability could have a material adverse effect on our business, financial condition or results of operations.

OUR MAIN SUPPLIERS OF VOICE PROCESSING BOARDS MAY BECOME UNWILLING OR UNABLE TO CONTINUE TO MANUFACTURE AND SUPPLY US WITH VOICE PROCESSING BOARDS, REQUIRING US TO INTRODUCE A SUBSTITUTE SUPPLIER WHICH COULD PROVE DIFFICULT OR COSTLY

Dialogic Corporation and AcuLab plc are our primary suppliers of the voice processing boards that are used by a majority of our end-user customers for the operation of our products. If a majority of future end-user customers desire to utilize the voice processing boards to enable our products and these suppliers become unable or unwilling to continue to manufacture and supply these voice processing boards in the volume, price and technical specifications we require, then we would have to adapt our products to a substitute supplier. We may not be able to successfully introduce voice processing boards made by a substitute supplier into the available versions of our products. In addition, introducing a substitute supplier of voice processing boards could result in unforeseen additional product development or customization costs and could also introduce hardware and software operating or compatibility problems. We cannot assure you that these issues will not affect product shipments, will not be costly to correct, will not damage our reputation in the markets in which we operate, or will not have a material adverse affect on our business, financial condition or results of operations.

In addition, Dialogic Corporation’s CT Media™ server software offers some of the functionality that our Interaction Center Platform® products provide and consequently could make it easier for competitors or potential competitors to provide products competitive with ours. If CT Media™ server software were to become an industry standard, our failure to adopt it could disadvantage us in competitive situations. In addition, although neither of our primary suppliers of voice processing boards nor their affiliates currently offer a product that competes with our Interaction Center Platform® products, they could potentially develop a competitive or superior product.

WE MAY NOT BE ABLE TO PROTECT OUR PROPRIETARY RIGHTS ADEQUATELY, WHICH COULD ALLOW THIRD PARTIES TO COPY OR OTHERWISE OBTAIN AND USE OUR TECHNOLOGY WITHOUT AUTHORIZATION

We regard our software products as proprietary. In an effort to protect our proprietary rights, we rely primarily on a combination of copyright, trademark and trade secret laws, as well as licensing and other agreements with consultants, suppliers, strategic and OEM partners, resellers and end-user customers, and employee and third-party non-disclosure agreements. These laws and agreements provide only limited

protection of our proprietary rights. In addition, we have not signed agreements containing these types of protective provisions in every case, and the contractual provisions that are in place and the protection they provide vary and may not provide us with adequate protection in all circumstances. We currently hold three patents and have filed numerous other patent applications relating to technology embodied in our software products. We hold 12 U.S. trademark registrations and 12 foreign trademark registrations, and have numerous other trademark applications pending worldwide, as well as having common law rights in other trademarks and service marks. We hold one registered copyright. Because our means of protecting our proprietary rights may not be adequate, it may be possible for a third party to copy or otherwise obtain and use our technology without authorization. A third party could also develop similar technology independently. In addition, the laws of some countries in which we sell our products do not protect our software and intellectual property rights to the same extent as the laws of the United States. Unauthorized copying, use or reverse engineering of our products could materially adversely affect our business, results of operations or financial condition.

We license technology that is embedded in our products from others. If one or more of these licenses terminates or cannot be renewed on satisfactory terms, we would have to modify the affected products to use alternative technology or eliminate the affected product function, either of which could have a material adverse effect on us.

INFRINGEMENT CLAIMS COULD ADVERSELY AFFECT US

In June 1999 and September 1999, we received letters from a competitor in the call center market claiming that our products utilize technologies pioneered and patented by that competitor. Our patent counsel has reviewed all of the patents listed in the letters. Based on the advice of our patent counsel, we believe that our products do not infringe any of the patents listed in either letter. We have discussed our conclusion with the competitor and have also discussed possible licensing of certain technologies from the competitor. Although we have not heard from this competitor since early 2001, we cannot assure you that this matter can be resolved amicably without litigation, or that we will ultimately be able to enter into a licensing arrangement on terms and conditions that would not have a material adverse effect on our business, financial condition or results of operations.

In June 2000 and October 2001, we received letters from a competitor in the outbound call center market claiming that our products utilize technologies pioneered and patented by the competitor. Although our patent counsel has not determined the validity of these patents, the Company has discussed the possible licensing of certain technologies from the competitor. Ownership of the technology has changed once since the original letters, and the technology and related business unit are being marketed for sale by their current owner, who has filed for bankruptcy protection. We cannot assure you that these claims can be resolved amicably without litigation, or that we will be able to enter into licensing arrangements on terms and conditions that would not have a material adverse effect on our business, financial condition or results of operations.

In July 2002, we received a letter from a consulting firm which has been retained by a telecommunication technology provider to develop and implement a licensing program based on the technology provider’s patents. The consulting firm believes a licensing agreement between the Company and the technology provider is appropriate. Our patent counsel is in the process of reviewing the patents listed in the letter. To date, our patent counsel has not determined the validity or applicability of these patents. We cannot assure you that this matter can be resolved amicably without litigation, or that we will be able to enter into a licensing arrangement on terms and conditions that would not have a material adverse effect on our business, financial condition or results of operations.

Other third parties could claim that our technology infringes their proprietary rights. As the number of software products in our target markets increases and the functionality of these products overlap, we believe that software developers may face infringement claims. For example, various patent rights have been asserted against interfaces between PBX hardware and computer network systems. Although we believe that our products do not infringe any of these patents because, among other reasons, our products are designed to replace PBXs and not to create such interfaces, if these patents were interpreted broadly, claims of infringement of these patents could have a material adverse affect on us.

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

WE DEPEND ON KEY PERSONNEL AND WILL NEED TO RECRUIT ADDITIONAL SKILLED PERSONNEL, FOR WHICH COMPETITION IS INTENSE, TO CONDUCT AND GROW OUR BUSINESS EFFECTIVELY

Our success depends in large part on the continued service of our key personnel, particularly Dr. Donald E. Brown, our Chief Executive Officer and principal stockholder. The loss of the services of Dr. Donald E Brown or any key personnel could have a material adverse effect on our business, financial condition or results of operations. We do not have key man life insurance on any of our employees. Our future success also depends on our ability to attract, train, assimilate and retain additional qualified personnel. Competition for persons with skills in the software industry is intense, particularly for those with relevant technical and/or sales experience. We cannot assure you that we will be able to retain our key employees or that we can attract, train, assimilate or retain other highly qualified personnel in the future.

OUR WORKFORCE REDUCTION AND FINANCIAL PERFORMANCE MAY ADVERSELY AFFECT THE MORALE AND PERFORMANCE OF OUR PERSONNEL AND OUR ABILITY TO HIRE NEW PERSONNEL

In connection with our effort to streamline operations, reduce costs and rationalize our staffing and structure, we had reductions in both 2001 and 2002 of our worldwide workforce of approximately 10% -12% each year. There were and may continue to be substantial costs associated with the workforce reductions related to severance and other employee-related costs, and our restructuring plans may still yield unanticipated consequences, such as attrition beyond our implemented reduction in workforce. As a result, our ability to respond to unexpected challenges may be impaired and we may be unable to take advantage of new opportunities. The reduction in workforce may reduce employee morale and may create concern among existing employees about job security, which may lead to increased turnover. These reductions in headcount may still subject us to the risk of litigation. In addition, recent trading levels of our common stock have decreased the value of the stock options granted to employees pursuant to our stock option plans. As a result of these factors, our remaining personnel may seek employment with larger, more established companies or companies they perceive as having less volatile stock prices.

WE MAY PURSUE ACQUISITIONS THAT BY THEIR NATURE PRESENT RISKS AND THAT MAY NOT BE SUCCESSFUL

In the future we may pursue additional acquisitions to diversify our product offerings and customer base or for other strategic purposes. We have no prior history of making material acquisitions and we cannot assure you that any future acquisitions will be successful. The following are some of the risks associated with acquisitions that could have a material adverse effect on our business, financial condition or results of operations:

• We cannot assure that any acquired businesses will achieve anticipated revenues, earnings or cash flow.

• We may be unable to integrate acquired businesses successfully and realize anticipated economic, operational and other benefits in a timely manner, particularly if we acquire a

business in a market in which we have limited or no current expertise, or with a corporate culture different from our own. If we are unable to integrate acquired businesses successfully, we could incur substantial costs and delays or other operational, technical or financial problems.

• Acquisitions could disrupt our ongoing business, distract management, divert resources and make it difficult to maintain our current business standards, controls and procedures.

• We may finance future acquisitions by issuing common stock for some or all of the purchase price. This could dilute the ownership interests of our stockholders. We may also incur additional debt or be required to recognize amortization expense related to goodwill and other intangible assets purchased in future acquisitions.

• We would be competing with other firms, many of which have greater financial and other resources, to acquire attractive companies. We believe this competition will increase, making it more difficult to acquire suitable companies on acceptable terms.

OUR INTERNATIONAL OPERATIONS INVOLVE FINANCIAL AND OPERATIONAL RISKS

Our international operations require significant management attention and financial resources to establish and operate, including hiring appropriate personnel and recruiting effective international resellers. Non-North American revenues accounted for 19%, 22%, and 25% of our total revenues in 2002, 2001, and 2000, respectively. To date, our products have been licensed outside North America primarily in Western Europe, South Africa, and Australia. We also have marketing efforts in Japan, Korea, China and Central and South America. We intend to continue to emphasize our international operations and we may enter additional international markets. Revenues from international operations may be inadequate to cover the expenses of those operations. In addition to foreign currency fluctuation risks described in the next risk factor, other risks inherent in our international business activities, in the countries in which we have licensed our products to date and in those countries in which we operate and could expand into, generally could include the following:

• economic and political instability;

• unexpected changes in foreign regulatory requirements and laws;

• tariffs and other trade barriers;

• timing, cost and potential difficulty of adapting our software products to the local language in those foreign countries that do not use the alphabet that English uses, such as Japan, Korea and China;

• lack of acceptance of our products in foreign countries;

• longer sales cycles and accounts receivable payment cycles;

• potentially adverse tax consequences;

• restrictions on the repatriation of funds; and

• increased government regulations related to increasing or reducing business activity in various countries.

FLUCTUATIONS IN THE VALUE OF FOREIGN CURRENCIES COULD RESULT IN LOSSES

Our international revenues are generally denominated in U.S. Dollars with the exception of some European resellers and end-user customers located in countries who have adopted the Euro as their official currency. Our international expenses are generally denominated in local foreign currencies. Although foreign currency translation gains and losses have been immaterial to date, fluctuations in exchange rates between the U.S. Dollar and other currencies could have a material adverse effect on our business, financial condition or results of operations, and particularly on our operating margins. To date, we have minimally sought to hedge the risks associated with fluctuations in exchange rates, but we may more actively undertake to do so in the future. Any hedging techniques we implement in the future may not be successful. Exchange rate fluctuations could also make our products more expensive than competitive products not subject to these fluctuations, which could adversely affect our revenues and profitability in international markets.

OUR PRODUCTS COULD HAVE DEFECTS FOR WHICH WE ARE POTENTIALLY LIABLE AND WHICH COULD RESULT IN LOSS OF REVENUE, INCREASED COSTS OR LOSS OF OUR CREDIBILITY OR DELAY IN ACCEPTANCE OF OUR PRODUCTS IN THE MARKET

Our products, including components supplied by others, may contain errors or defects, especially when first introduced or when new versions are released. Despite internal product testing, we have in the past discovered software errors in some of our products after their introduction. Errors in new products or releases could be found after commencement of commercial shipments, and this could result in additional development costs, diversion of technical and other resources from our other development efforts, or the loss of credibility with current or future end-user customers. This could result in a loss of revenue or delay in market acceptance of our products, which could have a material adverse effect on our business, financial condition or results of operations.

Our license agreements with our end-user customers typically contain provisions designed to limit our exposure to potential product liability and some contract claims. However, not all of these agreements contain these types of provisions and, where present, these provisions vary as to their terms and may not be effective under the laws of some jurisdictions. A product liability, warranty, or other claim brought against us could have a material adverse effect on our business, financial condition or results of operations.

Because our solution currently consists of our software running on a Windows NT® server and voice processing boards, it is inherently more prone to performance interruptions for our end-user customers than traditional non-software based products. Performance interruptions at our end-user customer sites, most of which currently do not have back-up systems, could affect demand for our products or give rise to claims against us.

WE MAY NOT BE ABLE TO OBTAIN ADEQUATE FINANCING TO IMPLEMENT OUR STRATEGY

Successful implementation of our strategy may require continued access to capital. If we do not generate sufficient cash from operations, our growth could be limited unless we are able to obtain capital through additional debt or equity financings. We cannot assure you that debt or equity financings will be available as required for acquisitions or other needs. Even if financing is available, it may not be on terms that are favorable to us or sufficient for our needs. If we are unable to obtain sufficient financing, we may be unable to fully implement our growth strategy.

OUR STOCK PRICE HAS BEEN AND COULD CONTINUE TO BE HIGHLY VOLATILE

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

• actual or anticipated fluctuations in our operating results;

• announcements by us, our competitors or our end-user customers;

• changes in financial estimates of securities analysts or investors regarding us, our industry, our competitors or our end-user customers;

• technological innovations by others;

• the operating and stock price performance of other comparable companies or of our competitors or end-user customers;

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

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

• general market or economic conditions.

This risk may be heightened because our industry is new and evolving, characterized by rapid technological change and susceptible to the introduction of new competing technologies or competitors.

In addition, the stock market has experienced significant price and volume fluctuations that have particularly affected the trading prices of equity securities of many technology companies, including us. These price and volume fluctuations often have been unrelated to the operating performance of the affected companies. In the past, following periods of volatility in the market price of a company’s securities, securities class action litigation has often been instituted against that company. This type of litigation, regardless of the outcome, could result in substantial costs and a diversion of management’s attention and resources, which could materially and adversely affect our business, financial condition or results of operations.

REGULATORY CHANGES MADE TO GENERALLY ACCEPTED ACCOUNTING PRINCIPLES OR CORPORATE GOVERNANCE MATTERS MAY IMPACT OUR BUSINESS

Revisions to generally accepted accounting principles will require us to review our accounting and financial reporting procedures in order to ensure continued compliance with required policies. From time to time, such changes may have a short-term impact in the reporting that we do, and these changes may impact market perception of our financial condition.

• Pending or new legislation may lead to an increase in our costs related to audits in particular and regulatory compliance generally

• Pending or new legislation may force us to seek other service providers for non-audit-related services, which may raise costs

• Changes in the legal climate may lead to additional liability fears which may result in increased insurance costs.

WE ARE SUBECT TO THE RISK OF TERRORISM, INCLUDING THE RESULTING POSSIBLE DISRUPTIONS IN BUSINESS ACTIVITIES AND LOSS OF BUSINESS

Our business can be affected by the disruptions caused by terrorist activities. Terrorist acts can create disruptions in our ordinary business activities, including, but not limited to communications, business travel, and the availability of key personnel and physical assets. Additionally, terrorist acts may cause uncertainty about business continuity and the effectiveness of our disaster recovery plans and the disaster recovery plans of our suppliers and resellers, and may adversely affect the confidence and behavior of our customers, employees, suppliers, and resellers.

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

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

Item 3. Quantitative and Qualitative Disclosures about Market Risk.

We develop products in the United States and sell licenses in North America, Europe, the Asia/Pacific region, South Africa, and Central and South America. As a result, our financial results could be affected by various factors, including changes in foreign currency exchange rates or weak economic conditions in foreign markets. As most sales are currently made in U.S. dollars, a strengthening of the dollar could make our products less competitive in foreign markets. Additionally, as our business matures in foreign markets, we may offer our products and services in certain local currencies. As a result, we will be subject to foreign currency fluctuations which may have an adverse affect on the company.

We manage our interest rate risk by maintaining an investment portfolio with debt instruments of high credit quality and relatively short average maturities. We also manage interest rate risk by maintaining sufficient cash and cash equivalent balances such that we are typically able to hold our investments to maturity.

Item 4. Controls and Procedures

We maintain a set of disclosure controls and procedures that are designed to ensure that information required to be disclosed by us in the reports filed by us under the Securities Exchange Act of 1934, as amended (“Exchange Act”) is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. Within the 90 days prior to the filing date of this report, we carried out an evaluation, under the supervision and with the participation of our management, including our President and Chief Executive Officer and our Chief Financial Officer and Treasurer, of the effectiveness of the design and operation of our disclosure controls and procedures pursuant to Rule 13a-14 of the Exchange Act. Based on that evaluation, our President and Chief Executive Officer and our Chief Financial Officer and Treasurer concluded that our disclosure controls and procedures are effective.

There have been no significant changes in our internal controls or other factors that could significantly affect those controls subsequent to the date of their evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.

PART II. OTHER INFORMATION

Item 1. Legal Proceedings.

See Note 5 of our Notes to the Condensed Consolidated Financial Statements for a description of various legal issues and contingencies.

We are also subject to ordinary and routine claims, lawsuits and proceedings incidental to our business, none of which is expected to be material to our results of operations, financial condition or cash flows.

Item 6. Exhibits and Reports on Form 8-K.

(a) Exhibits

99.1 Certification of Donald E. Brown, M.D., CEO, pursuant to 18 W.S. C. Section 1350

99.2 Certification of Keith A. Midkiff, CFO, pursuant to 18 W.S. C. Section 1350

(b) Reports on Form 8-K

On February 3, 2003, the Company filed a Current Report on Form 8-K under Item 5 to report that the Company was revising its accounting practice and would restate certain of its prior results to conform to Technical Practice Aid (TPA) 5100.53.

On February 13, 2003, the Company filed a Current Report on Form 8-K under Item 5 to report the Company’s fourth quarter and total 2002 results including the restatement of its prior results.

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

	Interactive Intelligence, Inc.
		(Registrant)

Date: May 14, 2003	By /s/ Keith A. Midkiff

	Keith A. Midkiff
	Chief Financial Officer, Secretary and Treasurer
	(Principal Financial Officer and Principal Accounting Officer)

CERTIFICATIONS

I, Donald E. Brown, M.D., certify that:

1. I have reviewed this quarterly report on Form 10-Q of Interactive Intelligence, Inc.;

2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report;

3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report;

4. The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:

a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared;

b) evaluated the effectiveness of the registrant’s disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the “Evaluation Date”); and

c) presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;

5. The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation, to the registrant’s auditors and the audit committee of registrant’s board of directors (or persons performing the equivalent function):

a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant’s ability to record, process, summarize and report financial data and have identified for the registrant’s auditors any material weaknesses in internal controls; and

b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controls; and

6. The registrant’s other certifying officer and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.

Date: May 14, 2003

	/s/ Donald E. Brown
	Donald E. Brown, M.D.
	President and Chief Executive Officer

I, Keith A. Midkiff, certify that:

1. I have reviewed this quarterly report on Form 10-Q of Interactive Intelligence, Inc.;

b) evaluated the effectiveness of the registrant’s disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the “Evaluation Date”); and

c) presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;

b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controls; and

Date: May 14, 2003

	/s/ Keith A. Midkiff
	Keith A. Midkiff
	Chief Financial Officer and Treasurer