- Quarterly Report (10-Q)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

____________

FORM 10-Q

(Mark One)

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

For the quarterly period ended September 30, 2008

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. Yes R No *

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	R

Non-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 17,051,677 shares outstanding of the registrant’s common stock, $0.01 par value.

TABL E OF CONTENTS

PART I. FINANCIAL INFORMATION		Page

Item 1.	Financial Statements.

	Condensed Consolidated Balance Sheets as of September 30, 2008 and December 31, 2007	3

	Condensed Consolidated Statements of Income for the Three and Nine Months Ended September 30, 2008 and 2007	4

	Condensed Consolidated Statement of Shareholders’ Equity for the Nine Months Ended September 30, 2008	5

	Condensed Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2008 and 2007	6

	Notes to Condensed Consolidated Financial Statements	7

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations.	13

Item 3.	Quantitative and Qualitative Disclosures About Market Risk.	19

Item 4.	Controls and Procedures.	20

PART II. OTHER INFORMATION

Item 1.	Legal Proceedings.	20

Item 1A.	Risk Factors.	20

Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds.	20

Item 6.	Exhibits.	21

SIGNATURE		21

PART I. FINANCIAL INFORMATION

Item 1. Condensed Consolidated Financial Statements and Notes to Condensed Consolidated Financial Statements.

I nteractive 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)
Assets
Current assets:
Cash and cash equivalents	$	34,476		$	29,359
Short-term investments		14,845			16,968
Accounts receivable, net of allowance for doubtful accounts of $904 at September 30, 2008 and $1,076 at December 31, 2007		25,231			27,527
Deferred tax assets, net		5,833			5,833
Prepaid expenses		5,297			5,501
Other current assets		2,513			1,414
Total current assets		88,195			86,602
Property and equipment, net		11,091			6,932
Deferred tax assets, net		5,735			7,520
Other assets, net		2,781			2,384
Total assets	$	107,802		$	103,438

Liabilities and Shareholders’ Equity
Current liabilities:
Accounts payable and accrued liabilities	$	12,856		$	9,594
Accrued compensation and related expenses		3,589			4,381
Deferred product revenues		5,104			6,843
Deferred services revenues		28,611			28,711
Total current liabilities		50,160			49,529
Noncurrent deferred services revenues		6,151			5,290
Total liabilities		56,311			54,819

Shareholders’ 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			179
Treasury stock		(3,357	)		--
Additional paid-in capital		82,750			79,405
Accumulated deficit		(28,079	)		(30,965	)
Total shareholders’ equity		51,491			48,619
Total liabilities and shareholders’ equity	$	107,802		$	103,438

See Accompanying Notes to Condensed Consolidated Financial Statements

I nteractive 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			2007
Revenues:
Product	$	14,687		$	15,526	$	44,853		$	42,484
Services		15,369			13,676		45,296			38,141
Total revenues		30,056			29,202		90,149			80,625
Cost of revenues:
Product		3,702			4,232		10,741			10,173
Services		6,059			5,533		18,044			15,475
Total cost of revenues		9,761			9,765		28,785			25,648
Gross profit		20,295			19,437		61,364			54,977
Operating expenses:
Sales and marketing		9,569			9,286		29,889			26,762
Research and development		5,801			4,348		16,102			12,472
General and administrative		3,560			3,310		11,269			9,660
Total operating expenses		18,930			16,944		57,260			48,894
Operating income		1,365			2,493		4,104			6,083
Other income (expense):
Interest income, net		329			412		1,132			1,268
Other income (expense), net		(71	)		29		(26	)		(69	)
Total other income, net		258			441		1,106			1,199
Income before income taxes		1,623			2,934		5,210			7,282
Income tax benefit (expense)		(699	)		37		(2,324	)		(163	)
Net income	$	924		$	2,971	$	2,886		$	7,119

Net income per share:
Basic	$	0.05		$	0.17	$	0.16		$	0.41
Diluted		0.05			0.15		0.15			0.37

Shares used to compute net income per share:
Basic		17,976			17,461		17,969			17,388
Diluted		18,855			19,407		19,059			19,336

See Accompanying Notes to Condensed Consolidated Financial Statements

Interactive Intelligence, Inc.

Condensed Consolidated Statement of Shareholders’ Equity (unaudited)

For the Nine Months Ended September 30, 2008

(In thousands)

							Additional
	Common Stock						Paid-in			Treasury			Accumulated
	Shares			Amount			Capital			Stock			Deficit			Total
Balances, December 31, 2007		17,901		$	179		$	79,405		$	--		$	(30,965	)	$	48,619
Issuances of common stock		15			--			205			--			--			205
Exercise of stock options		187			2			715			98			--			815
Stock-based compensation		--			--			2,315			--			--			2,315
Stock option income tax benefits		--			--			177			--			--			177
Purchase of treasury stock		(353	)		(4	)		--			(3,455	)		--			(3,459	)
Comprehensive income:
Net income		--			--			--			--			2,886			2,886
Net unrealized investment loss		--			--			(67	)		--			--			(67	)
Total comprehensive income		--			--			(67	)		(3,357	)		2,886			2,819
Balances, September 30, 2008		17,750		$	177		$	82,750		$	(3,357	)	$	(28,079	)	$	51,491

See Accompanying Notes to Condensed Consolidated Financial Statements

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			2007
Operating activities:
Net income	$	2,886		$	7,119
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation		2,621			1,941
Stock-based compensation expense		2,315			2,286
Deferred 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	)		216
Other assets		(397	)		(49	)
Accounts payable and accrued liabilities		2,845			1,192
Accrued compensation and related expenses		(792	)		662
Deferred product revenues		(1,505	)		908
Deferred services revenues		527			4,682
Net cash provided by operating activities		11,405			9,832

Investing activities:
Sales of available-for-sale investments		20,050			18,115
Purchases 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			1,628
Proceeds from issuance of common stock		205			150
Excess tax benefits from stock-based payment arrangements		177			--
Repurchase of treasury stock		(3,361	)		--
Net cash provided by (used in) financing activities		(2,262	)		1,778

Net increase in cash and cash equivalents		5,117			9,899
Cash and cash equivalents, beginning of period		29,359			13,531
Cash and cash equivalents, end of period	$	34,476		$	23,430

Cash paid during the period for:
Income taxes	$	195		$	147

Other non-cash item:
Purchases of property and equipment payable at end of period	$	594		$	--

See Accompanying Notes to Condensed Consolidated Financial Statements

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.

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):

	Fair Value Measurements at Reporting Date Using
Description	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		2007
Net income, as reported (A)	$	924	$	2,971	$	2,886	$	7,119

Weighted average shares of common stock outstanding (B)		17,976		17,461		17,969		17,388
Dilutive effect of employee stock options		879		1,946		1,089		1,948
Common stock and common stock equivalents (C)		18,855		19,407		19,059		19,336

Net income per share:
Basic (A/B)	$	0.05	$	0.17	$	0.16	$	0.41
Diluted (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.

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		2007
Stock-based compensation expense by category:
Cost of services	$	13	$	70	$	154	$	184
Sales and marketing		132		313		876		943
Research and development		205		157		637		419
General and administrative		89		272		648		739
Total 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			2007
Dividend 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			2007
Dividend 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

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, 2008
	Options			Weighted- Average Exercise Price


Balances, beginning of year		3,232,483		$	8.71
Options granted		588,065			15.22
Options exercised		(186,883	)		4.35
Options cancelled		(59,000	)		12.73
Options outstanding, nine months ended		3,574,665			9.94
Option price range	$	2.51 - 50.50
Weighted-average fair value of options granted during the nine months ended	$	7.80
Options exercisable		2,087,516		$	7.36
Options 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.

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			2007
Expected 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			162
Change in deferred tax asset valuation allowance		--			1,359			--			3,192
Other		(45	)		--			185			--
Income tax benefit (expense)	$	(699	)	$	37		$	(2,324	)	$	(163	)

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

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.

			Increase
Period	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.

	Three Months Ended September 30,						Nine Months Ended September 30,
	2008			2007			2008			2007
Revenues:
Product		49	%		53	%		50	%		53	%
Services		51			47			50			47
Total revenues		100			100			100			100
Cost of revenues:
Product		12			14			12			13
Services		20			19			20			19
Total cost of revenues		32			33			32			32
Gross profit		68			67			68			68
Operating expenses:
Sales and marketing		32			32			33			33
Research and development		19			15			18			16
General and administrative		12			11			12			12
Total operating expenses		63			58			63			61
Operating income		5			9			5			7
Other income (expense):
Interest income, net		1			1			1			2
Other income (expense), net		--			--			--			--
Total other income		1			1			1			2
Income before income taxes		6			10			6			9
Income 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 Ended
Product Revenues	September 30,						September 30,
	2008			2007			2008			2007
	($ in thousands)
Product revenues	$	14,687		$	15,526		$	44,853		$	42,484
Change 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		$	38,141
Change 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.

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		$	10,173
Services		6,059			5,533			18,044			15,475
Total cost of revenues	$	9,761		$	9,765		$	28,785		$	25,648
Change 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		$	54,977
Change 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.

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		$	26,762
Change 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		$	12,472
Change 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. F or 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		$	9,660
Change 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.

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		$	30,733
Interest income		329			412			1,132			1,268
Return 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	$	29,359
Short-term investments		14,845		16,968
Liquidity, 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.

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.

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 Program
July 1, 2008–July 31, 2008		--		--		--		--
Aug 1, 2008–Aug 31,2008		70,178	$	9.73		70,178	$	9,332,289
Sept 1, 2008–Sept 30, 2008		283,073		9.84		283,073	$	6,559,621
Total		353,251	$	9.82		353,251

(1) Represents the number of shares repurchased through our repurchase program authorized by our Board of Directors.

Item 6.

Exhibits.

(a)

Exhibits

Incorporated by Reference

Exhibit Number

Exhibit Description

Form

Exhibit

Filing Date

Filed Herewith

3.1

Restated Articles of Incorporation of the Company, as currently in effect

S-1

(Registration No. 333-79509)

3.1

5/28/1999

3.2

Amended By-Laws of the Company, as currently in effect

8-K

3.2

8/21/2007

31.1

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

31.2

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

32.1

Certification of 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

32.2

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

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. Head
		Stephen R. Head Chief Financial Officer, Vice President of Finance and Administration, Secretary and Treasurer (Principal Financial Officer and Principal Accounting Officer)