- 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, 2010

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 has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

Yes ¨

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

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 29, 2010, there were 17,814,499 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, 2010 and December 31, 2009		1

	Condensed Consolidated Statements of Income for the Three and Nine Months Ended September 30, 2010 and 2009		2

	Condensed Consolidated Statement of Shareholders’ Equity for the Nine Months Ended September 30, 2010		3

	Condensed Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2010 and 2009		4

	Notes to Condensed Consolidated Financial Statements		5

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations.		10

Item 3.	Quantitative and Qualitative Disclosures About Market Risk.		18

Item 4.	Controls and Procedures.		18

PART II. OTHER INFORMATION

Item 1.	Legal Proceedings.		18

Item 1A.	Risk Factors.		18

Item 6.	Exhibits.		19

SIGNATURE			20

PART I. FINANCIAL INFORMATION

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

Interactive Intelligence, Inc.

Condensed Consolidated Balance Sheets

As of September 30, 2010 and December 31, 2009

(In thousands, except share and per share amounts)

	September 30, 2010			December 31, 2009
Assets	(unaudited)
Current assets:
Cash and cash equivalents	$	49,688		$	48,497
Short-term investments		35,842			16,482
Accounts receivable, net of allowance for doubtful accounts of $1,060 at September 30, 2010 and $1,094 at December 31, 2009		32,417			32,092
Deferred tax assets, net		5,499			5,808
Prepaid expenses		7,754			5,976
Other current assets		5,039			3,935
Total current assets		136,239			112,790
Property and equipment, net		8,925			8,499
Deferred tax assets, net		6,870			6,505
Other assets, net		4,844			4,874
Total assets	$	156,878		$	132,668

Liabilities and Shareholders’ Equity
Current liabilities:
Accounts payable and accrued liabilities	$	14,511		$	11,903
Accrued compensation and related expenses		5,669			4,946
Deferred product revenues		4,950			5,567
Deferred services revenues		40,456			36,225
Total current liabilities		65,586			58,641
Deferred revenue		6,398			6,420
Total liabilities		71,984			65,061

Commitments and contingencies (Note 7)		--			--

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; 17,568,613 issued and outstanding at September 30, 2010 and 17,276,990 issued and outstanding at December 31, 2009		176			173
Treasury stock, at cost; 524,252 shares as of September 30, 2010 and 815,875 shares as of December 31, 2009		(3,973	)		(6,242	)
Additional paid-in capital		100,199			92,815
Accumulated deficit		(11,508	)		(19,139	)
Total shareholders’ equity		84,894			67,607
Total liabilities and shareholders’ equity	$	156,878		$	132,668

See Accompanying Notes to Condensed Consolidated Financial Statements

Interactive Intelligence, Inc.

Condensed Consolidated Statements of Income (unaudited)

For the Three and Nine Months Ended September 30, 2010 and 2009

(In thousands, except per share amounts)

	Three Months Ended September 30,				Nine Months Ended September 30,
	2010		2009		2010			2009
Revenues:
Product	$	20,586	$	15,557	$	54,484		$	45,100
Services		21,245		17,613		61,181			50,441
Total revenues		41,831		33,170		115,665			95,541
Cost of revenues:
Product		6,198		3,950		16,499			12,320
Services		6,767		5,549		18,552			16,758
Total cost of revenues		12,965		9,499		35,051			29,078
Gross profit		28,866		23,671		80,614			66,463
Operating expenses:
Sales and marketing		12,106		9,696		33,939			28,877
Research and development		7,193		6,135		20,562			17,747
General and administrative		3,960		3,562		11,859			10,166
Total operating expenses		23,259		19,393		66,360			56,790
Operating income		5,607		4,278		14,254			9,673
Other income (expense):
Interest income		120		50		228			232
Other income (expense), net		337		480		(1,029	)		706
Total other income (expense), net		457		530		(801	)		938
Income before income taxes		6,064		4,808		13,453			10,611
Income tax expense		2,561		2,005		5,627			4,488
Net income	$	3,503	$	2,803	$	7,826		$	6,123

Net income per share:
Basic	$	0.20	$	0.16	$	0.45		$	0.36
Diluted		0.19		0.15		0.42			0.34

Shares used to compute net income per share:
Basic		17,524		17,148		17,431			17,038
Diluted		18,695		18,486		18,731			18,125

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, 2010

(In thousands)

	Common Stock				Treasury			Additional Paid-in			Accumulated
	Shares		Stock		Stock			Capital			Deficit			Total
Balances, December 31, 2009		17,277	$	173	$	(6,242	)	$	92,815		$	(19,139	)	$	67,607

Stock-based compensation		--		--		--			3,002			--			3,002
Exercise of stock options		277		3		2,149			(127	)		(195	)		1,830
Issuances of common stock		15		--		120			141			--			261
Tax benefits from stock-based payment arrangements		--		--		--			4,528			--			4,528
Comprehensive income:
Net income		--		--		--			--			7,826			7,826
Net unrealized investment gain		--		--		--			(160	)		--			(160	)
Total comprehensive income		--		--		--			(160	)		7,826			7,666
Balances, September 30, 2010		17,569	$	176	$	(3,973	)	$	100,199		$	(11,508	)	$	84,894

See Accompanying Notes to Condensed Consolidated Financial Statements

Interactive Intelligence, Inc.

Condensed Consolidated Statements of Cash Flows (unaudited)

For Nine Months Ended September 30, 2010 and 2009

(In thousands)

	Nine Months Ended September 30,
	2010			2009
Operating activities:
Net income	$	7,826		$	6,123
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation		3,107			3,139
Stock-based compensation expense		3,002			2,547
Tax benefits from stock-based payment arrangements		(4,528	)		(2,814	)
Deferred income tax		(56	)		884
Accretion of investment income		(407	)		(172	)
Changes in operating assets and liabilities:
Accounts receivable		(325	)		2,872
Prepaid expenses		(1,778	)		1,009
Other current assets		(1,104	)		(1,928	)
Other assets		30			281
Accounts payable and accrued liabilities		7,143			1,969
Accrued compensation and related expenses		723			1,043
Deferred product revenues		(717	)		(1,349	)
Deferred services revenues		4,309			(566	)
Net cash provided by operating activities		17,225			13,038

Investing activities:
Sales of available-for-sale investments		15,565			13,100
Purchases of available-for-sale investments		(34,678	)		(11,550	)
Purchases of property and equipment		(3,540	)		(1,275	)
Acquisition of intangible and other assets, net of cash and cash equivalents		--			(2,249	)
Net cash used in investing activities		(22,653	)		(1,974	)

Financing activities:
Proceeds from stock options exercised		1,830			1,812
Proceeds from issuance of common stock		261			189
Tax benefits from stock-based payment arrangements		4,528			2,814
Net cash provided by financing activities		6,619			4,815

Net increase in cash and cash equivalents		1,191			15,879
Cash and cash equivalents, beginning of year		48,497			34,705
Cash and cash equivalents, end of year	$	49,688		$	50,584

Cash paid during the year for:
Interest	$	1		$	--
Income taxes		716			533

Other non-cash item:
Purchase of property and equipment payable at end of period	$	22		$	42

See Accompanying Notes to Condensed Consolidated Financial Statements

Interactive Intelligence, Inc.

Notes to Condensed Consolidated Financial Statements

September 30, 2010 and 2009 (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 (“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 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 financial statements as of December 31, 2009 have been derived from the Company’s audited consolidated financial statements at that date but do not include all of the information and notes required by 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, 2009, included in the Company’s most recent Annual Report on Form 10-K as filed with the SEC on March 16, 2010. 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.

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, 2009.

During the nine months ended September 30, 2010, there were no material changes to the Company’s significant accounting policies or critical accounting estimates.

In September 2009, the Financial Accounting Standards Board (“FASB”) issued FASB Accounting Standards Update (“ASU”) 2009-13, Multiple-Deliverable Revenue Arrangements , which addresses criteria for separating consideration in multiple-element arrangements. The guidance requires companies allocating the overall consideration to each deliverable to use an estimated selling price of individual deliverables in the arrangement in the absence of vendor-specific objective evidence or other third-party evidence of the selling price for the deliverables. This guidance will be effective for fiscal years beginning on or after June 15, 2010 and early adoption is permitted. The Company anticipates adopting this guidance on January 1, 2011 and has not determined the effect that the adoption of this guidance will have on its condensed consolidated financial statements.

In September 2009, the FASB issued FASB ASU 2009-14, Certain Revenue Arrangements that Include Software Elements , which excludes from the scope of the FASB’s software revenue guidance tangible products that contain both software and non-software components that function together to deliver a product’s essential functionality. This guidance will be effective prospectively for revenue arrangements entered into or materially modified in fiscal years beginning on or after June 15, 2010 with early adoption permitted. If a company chooses to early adopt this guidance and the adoption is not at the beginning of its fiscal year, the requirements must be applied retrospectively to the beginning of the fiscal year. The Company anticipates adopting this guidance on January 1, 2011 and has not determined the effect that the adoption of this guidance will have on its condensed consolidated financial statements.

3.	FAIR VALUE MEASUREMENTS

FASB ASC 820, as amended, 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. FASB ASC 820 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 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 money market securities. Such instruments are 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 corporate notes, agency bonds, T-bills and commercial paper. Such instruments are 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 as of September 30, 2010 (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	$	19,880	$	19,880	$	--	$	--
Total	$	19,880	$	19,880	$	--	$	--

Short-term investments:
Commercial Paper	$	849	$	--	$	849	$	--
Agency Bonds		8,830		--		8,830		--
Corporate Notes		19,765		--		19,765		--
T-Bills		6,398		--		6,398		--
Total	$	35,842	$	--	$	35,842	$	--

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 FASB ASC Topic 260, 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. When the Company reports net income, 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,
	2010		2009		2010		2009
Net income, as reported (A)	$	3,503	$	2,803	$	7,826	$	6,123

Weighted average shares of common stock outstanding (B)		17,524		17,148		17,431		17,038
Dilutive effect of employee stock options		1,171		1,338		1,300		1,087
Common stock and common stock equivalents (C)		18,695		18,486		18,731		18,125

Net income per share:
Basic (A/B)	$	0.20	$	0.16	$	0.45	$	0.36
Diluted (A/C)		0.19		0.15		0.42		0.34

The Company’s calculation of diluted net income per share for the three months ended September 30, 2010 and 2009 excludes stock options to purchase approximately 924,000 and 768,000 shares of the Company’s common stock, respectively, as their effect would be anti-dilutive. The diluted net income per share for the nine months ended September 30, 2010 and 2009 excludes stock options to purchase approximately 911,000 and 1.1 million shares of the Company’s common stock, respectively, as their effect would be anti-dilutive.

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 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. A maximum of 7,050,933 shares are available for delivery under the 2006 Plan, which consists of (i) 3,350,000 shares, plus (ii) 320,000 shares available for issuance under the 1999 Plans, but not underlying any outstanding stock options or other awards under the 1999 Plans, plus (iii) up to 3,380,933 shares subject to outstanding stock options or other awards under the 1999 Plans that expire, are forfeited or otherwise terminate unexercised on or after May 18, 2006. The number of shares available under the 2006 Plan is subject to adjustment for certain changes in the Company’s capital structure. The exercise price of options granted under the 2006 Plan is equal to the closing price of the Company’s common stock, as reported by The NASDAQ Global Select Market, on the business day immediately preceding the date of grant.

Stock options granted by the Company are categorized into three types. The first type of stock options granted by the Company to employees and newly-elected non-employee directors is non-performance-based stock options that are subject only to time-based vesting. These stock options vest in four equal annual installments beginning one year after the grant date. 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.

The second type is performance-based stock options that are subject to cancellation if the specified performance targets are not met. If the applicable performance targets have been achieved, the options will vest in four equal annual installments beginning one year after the performance-related period has ended. The fair value of these stock 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.

Commencing in May 2009, the Company began granting its non-employee directors options annually that are similar to the non-performance-based options described above except the director options vest one year after the grant date (“annual director options”). The fair value of these annual director option grants is determined on the date of the grant and the related compensation expense is recognized over one year. Prior to May 2009, non-employee directors received non-performance-based stock options that vested over four years.

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 FASB ASC Topic 718, Compensation – Stock Compensation for the three and nine months ended September 30, 2010 and 2009 (in thousands):

	Three Months Ended September 30,				Nine Months Ended September 30,
	2010		2009		2010		2009
Stock-based compensation expense by category:
Cost of services	$	86	$	71	$	228	$	186
Sales and marketing		332		352		971		890
Research and development		285		254		881		726
General and administrative		326		298		922		745
Total stock-based compensation expense	$	1,029	$	975	$	3,002	$	2,547

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 the Company’s Annual Report on Form 10-K for the year ended December 31, 2009. The weighted-average estimated per option value of non-performance-based and performance-based options granted during the nine months ended September 30, 2010 and 2009 used the following assumptions:

	Nine Months Ended September 30,
Valuation assumptions for non-performance-based options:	2010			2009
Dividend yield		--	%		--	%
Expected volatility		67.75 - 69.10	%		67.88 – 69.08	%
Risk-free interest rate		1.72 - 2.06	%		1.64 – 2.36	%
Expected life of option (in years)		4.25			4.25

Prior to May 2009, directors were granted options that vested over four years. The fair value of these options was estimated using the non-performance-based option valuation assumptions set forth above. The Company granted non-performance based options during the first two quarters of 2010 and during the first three quarters of 2009. There were no non-performance based options granted during the third quarter of 2010.

Valuation assumptions for performance-based options:	2010			2009
Dividend yield		--	%		--	%
Expected volatility		67.81	%		67.35	%
Risk-free interest rate		2.30	%		1.77	%
Expected life of option (in years)		4.75			4.75

The Company granted performance-based options during the first quarters of 2010 and 2009.

Valuation assumptions for annual director options:	2010			2009
Dividend yield		--	%		--	%
Expected volatility		64.43	%		71.48	%
Risk-free interest rate		1.41	%		2.01	%
Expected life of option (in years)		3.50			3.50

The Company granted annual director options that vest one year after the grant date during the second quarters of 2010 and 2009.

Stock Option Activity

The following table sets forth a summary of option activity for the nine months ended September 30, 2010:

	As of September 30, 2010
	Options			Weighted- Average Exercise Price

Balances, beginning of year		3,425,743		$	9.36
Options granted		566,500			19.61
Options exercised		(276,774	)		6.61
Options cancelled, forfeited or expired		(37,451	)		25.96
Options outstanding		3,678,018			10.95
Option price range	$	2.51 – 38.75
Weighted-average fair value of options granted	$	10.57
Options exercisable		2,385,425		$	8.70
Options available for grant		1,742,554

6.	CONCENTRATION OF CREDIT RISK

No customer or partner accounted for more than 10% of the Company’s accounts receivable as of September 30, 2010. One partner accounted for 13% of the Company’s accounts receivable as of December 31, 2009. No customer or partner accounted for 10% or more of the Company’s revenues for the three and nine months ended September 30, 2010 and 2009, and no country other than the United States accounted for more than 10% of the Company's revenues in those periods.

7.	COMMITMENTS AND CONTINGENCIES

Legal Proceedings

From time to time, the Company is involved in certain legal proceedings in the ordinary course of conducting its business, including but not limited to infringement of proprietary rights claims by competitors and other technology providers. 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.

Guarantees

The Company provides to customers indemnifications of varying scope and amounts against claims of intellectual property infringement made by third parties arising from the use of its products. The Company’s software license agreements, in accordance with FASB ASC Topic 460, Guarantees , include certain provisions for indemnifying customers, in material compliance with their license agreement, against liabilities if the Company’s software products infringe upon a third party's intellectual property rights, over the life of the agreement. The Company is not able to estimate the potential exposure related to the indemnification provisions of its license agreements but has not incurred expenses under these indemnification provisions. The Company may at any time and at its option and expense: (i) procure the right of the customer to continue to use the Company’s software that may infringe a third party’s rights; (ii) modify its software so as to avoid infringement; or (iii) require the customer to return its software and refund the customer the fee actually paid by the customer for its software less depreciation based on a five-year straight-line depreciation schedule. The customer’s failure to provide timely notice or reasonable assistance will relieve the Company of its obligations under this indemnification to the extent that it has been actually and materially prejudiced by such failure. To date, the Company has not incurred, nor does it expect to incur, any material related costs and, therefore, has not reserved for such liabilities.

The Company’s software license agreements also include a warranty that its software products will substantially conform to its software user documentation for a period of one year, provided the customer is in material compliance with the software license agreement. To date, the Company has not incurred any material costs associated with these product warranties, and as such, has not reserved for any such warranty liabilities.

Lease Commitments and Other Contingencies

The Company leases space for its world headquarters in Indianapolis, Indiana under an operating lease agreement and amendments which expire on March 31, 2018. The Company also has multiple leases for offices and other space throughout the world. The office space for sales, services, development and international offices are rented under operating leases and expire at various times through 2016. In accordance with FASB ASC Topic 840, Leases , rental expense is recognized ratably over the lease period, including those leases containing escalation clauses.

Other Contingencies

The Company has received and may continue to receive certain payroll tax credits and real estate tax abatements that were granted to the Company based upon certain growth projections. If the Company’s actual results are less than those projections, the Company may be subject to repayment of some or all of the 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.

8.	INCOME TAXES

The following table sets forth the items accounting for the difference between expected income tax expense at the 35% federal statutory rate compared to actual income tax expense recorded in the Company’s condensed consolidated financial statements (in thousands):

	Three Months Ended September 30,						Nine Months Ended September 30,
	2010			2009			2010			2009
Expected income tax expense at 35% tax rate	$	2,122		$	1,674		$	4,709		$	3,705
State taxes, net of federal benefit		424			249			952			563
Stock-based compensation expense related to non-deductible stock option expense		72			147			238			395
Research tax credit		--			(63	)		--			(189	)
Disqualifying dispositions		(74	)		--			(251	)		--
Other		17			(2	)		(21	)		14
Income tax expense	$	2,561		$	2,005		$	5,627		$	4,488

FASB ASC Topic 740, Income Taxes , prescribes a recognition threshold and measurement attributes for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. The Company has identified an uncertain tax position related to certain 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 full valuation allowance established. The balance of the reserve was approximately $910,000 at December 31, 2009. As of September 30, 2010, the reserve 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 2006 and forward remain open for examination for federal tax purposes and tax years 2005 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, 2009 will remain subject to examination until the respective tax year is closed.

During the third quarter of 2010, the Company utilized its remaining net operating losses generated from the exercise of stock options in prior years and began utilizing deferred tax assets generated from foreign withholding credits. At September 30, 2010, the Company had approximately $5.6 million of alternative minimum tax, federal and state research tax credit carryforwards and foreign tax credits available to offset taxes payable.

9.	ACQUISITION

Stock Purchase Agreement

The Company entered into a stock purchase agreement, dated as of October 5, 2010, with Global Software Services, Inc., doing business as Latitude Software (“Latitude”), a privately-held provider of accounts receivable management software and services. The Company acquired Latitude consistent with its strategy to supplement organic growth with strategic industry-specific applications and expertise that leverage the Company’s core technology platform.

Pursuant to the terms of the stock purchase agreement, the Company purchased 100% of the outstanding capital stock of Latitude for an aggregate purchase price of $14.0 million, funded with cash on hand. The Company deposited $1.0 million of the purchase price into an escrow account to ensure funds are available to pay indemnification claims, if any. Latitude will operate as a subsidiary of the Company and will maintain its current headquarters in Jacksonville, Florida.

The Company is in the process of preparing an allocation of the purchase price to the fair value of assets acquired and liabilities assumed, but expects that a substantial portion of the purchase price will be allocated to intangible assets including trade name, customer relationships, core technology, non-competition agreements and goodwill. The acquisition will be accounted for using the acquisition method of accounting in accordance with FASB ASC Topic 805, Business Combinations . As the acquisition took place subsequent to September 30, 2010, the results of Latitude’s operations were not included in the Company’s condensed consolidated financial statements as of and for the three and nine months ended September 30, 2010.

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 Part I, Item 1A “Risk Factors” section of our Annual Report on Form 10-K for the fiscal year ended December 31, 2009. The following will be discussed and analyzed:

·	Forward-Looking Information

Overview

·	Financial Highlights

·	Historical Results of Operations

·	Comparison of Three and Nine Months Ended September 30, 2010 and 2009

·	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 (the “Exchange Act”)) 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 the 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, to manage successfully our increasingly complex third-party relationships resulting from the software and hardware components being licensed or sold with our solutions, to maintain successful relationships with certain suppliers which may be impacted by competition in the technology industry, to maintain successful relationships with our current and any new partners, to maintain and improve our current products, to develop new products, to protect our proprietary rights adequately, to successfully integrate acquired businesses and other factors set forth in our Securities and Exchange Commission (“SEC”) filings.

Overview

Interactive Intelligence, Inc. (“we”, “us” or “our”) was formed in 1994 as an Indiana corporation and maintains its world headquarters and executive offices at 7601 Interactive Way, Indianapolis, IN 46278. Our telephone number is (317) 872-3000. We are located on the web at http://www.inin.com . We file annual, quarterly and current reports, proxy statements and other documents with the SEC under the Exchange Act. These periodic and current reports and all amendments to those reports are available free of charge on the investor relations page of our website at http://investors.inin.com .

We are a leading provider of software application suites for Voice over Internet Protocol (“VoIP”) business communications and are increasingly leveraging our leadership position in the worldwide contact center market to offer our solutions to enterprises. Businesses and organizations, including those that employ remote and mobile workers, utilize our solutions in industries including, but not limited to, teleservices, financial services (banks, credit unions, accounts receivable management), insurance, higher education, healthcare, retail, technology, government and business services. Our innovative software products and services are designed for:

·	Multichannel contact management and business communications (voice and messaging) using the Session Initiation Protocol (“SIP”) global communications standard that supports VoIP;

·	Business process automation (“BPA”) using a communications-based approach; and

·	Content management, including document as well as workflow management.

With our single software platform, organizations can replace various traditional “multipoint” communications products. Our solutions incorporate a full-featured media server, media gateways, SIP proxy, and SIP station voice device for Internet Protocol (“IP”)-based communications networks and infrastructures. Customers can deploy our solutions on-premises or in a Communications as a Service (“CaaS”) model using a hosted data center.

Our solutions integrate with business systems and end-user devices, enhance the mobility of today’s remote workforce, scale to thousands of users, manage content in large volumes, provide communications and data security, and satisfy a range of business communications and interaction management needs for:

·	The Contact Center

·	Enterprise IP Telephony

·	Business Process Automation

By implementing our all-in-one solutions, businesses are able to unify multichannel communications media (phone, fax, e-mail, web chat, content) and information, automate business processes, enhance workforce performance and productivity, improve customer service processes, and readily adapt to changing market and customer requirements. Contact centers can leverage our platform to support thousands of agents, including remote “Work-at-Home” agents, and handle inbound, outbound and “blended” inbound/outbound interactions, at one location or throughout multi-site contact center operations. Our enterprise IP telephony solutions provide call control and messaging for mid- and large-sized business enterprises with 100 to several hundred thousand users, with the ability to scale user counts up or down as needed. Enterprises, contact centers, and other organizations can utilize our BPA solutions to automate processes using an approach that incorporates communications functionality such as routing, quality monitoring, and the ability to indicate employee availability. These solutions can be delivered on-premise or via a hosted cloud-based data center such as CaaS.

For further information on our business and the products and services we offer, refer to the Part I, Item 1 “Business” section of our Annual Report on Form 10-K for the year ended December 31, 2009.

Our management monitors certain key measures to assess our financial results. In particular, we track trends on product orders, contracted professional services, and CaaS orders from quarter to quarter and in comparison to the prior year actual results and current year plan amounts. We also review leading market indicators to look for trends in economic conditions. In addition to orders and revenues, management reviews costs of revenue and operating expenses including staffing levels which affect salaries, our largest expense, to ensure we are managing new expenditures and controlling costs. For additional discussions regarding trends and our expectations for 2010, see “Financial Highlights” beginning on page 12.

In addition to the above, our management monitors diluted earnings per share (“EPS”), which is a key measure of performance that is also used by analysts and investors, on both a GAAP and non-GAAP basis. Management uses non-GAAP EPS, net income and operating income, which exclude non-cash stock-based compensation expense and non-cash income tax expense, to analyze our business. These measures are not in accordance with, or an alternative for, GAAP and may be different from non-GAAP measures used by other companies. Stock-based compensation expense is non-cash and income tax expense is primarily non-cash. We believe that the presentation of non-GAAP results, when shown in conjunction with corresponding GAAP measures, provides useful information to our management and investors regarding financial and business trends related to our results of operations. Further, our management believes that these non-GAAP measures improve management’s and investors’ ability to compare our financial performance with other companies in the technology industry. Because stock-based compensation expense and non-cash income tax expense amounts can vary significantly between companies, it is useful to compare results excluding these amounts. Our management also uses financial statements that exclude stock-based compensation expense related to stock options and non-cash income tax expense for our internal budgets.

Reconciliations of these non-GAAP measures to the most directly comparable GAAP measures are included below (in thousands, except per share amounts):

	Three Months Ended September 30,				Nine Months Ended September 30,
	2010		2009		2010		2009

Net income, as reported	$	3,503	$	2,803	$	7,826	$	6,123
Non-cash stock-based compensation expense:
Cost of services		86		71		228		186
Sales and marketing		332		352		971		890
Research and development		285		254		881		726
General and administrative		326		298		922		745
Total		1,029		975		3,002		2,547
Non-cash income tax expense		2,410		1,913		5,196		4,257
Non-GAAP net income	$	6 , 942	$	5,691	$	16,024	$	12,927

Operating income, as reported	$	5,607	$	4,278	$	14,254	$	9,673
Non-cash stock-based compensation expense		1,029		975		3,002		2,547
Non-GAAP operating income	$	6,636	$	5,253	$	17 , 256	$	12,220

Diluted EPS, as reported	$	0.19	$	0.15	$	0.42	$	0.34
Non-cash stock-based compensation expense		0.0 6		0.0 5		0.16		0.14
Non-cash income tax expense		0. 12		0. 11		0. 28		0. 23
Non-GAAP diluted EPS	$	0.37	$	0.31	$	0.86	$	0.71

Latitude Acquisition

We entered into a stock purchase agreement, dated as of October 5, 2010, with Global Software Services, Inc., doing business as Latitude Software (“Latitude”), a privately-held provider of accounts receivable management software and services. Pursuant to the terms of the stock purchase agreement, we purchased 100% of the outstanding capital stock of Latitude for an aggregate purchase price of $14.0 million, funded with cash on hand. We deposited $1.0 million of the purchase price into an escrow account to ensure funds are available to pay indemnification claims, if any. Latitude will operate as our subsidiary and will maintain its current headquarters in Jacksonville, Florida. As the acquisition took place subsequent to September 30, 2010, the results of Latitude’s operations were not included in our condensed consolidated financial statements as of and for the three and nine months ended September 30, 2010.

We acquired Latitude consistent with our strategy to supplement organic growth with strategic industry-specific applications and expertise that leverage our core technology platform. We have seen increased demand for our communications software suite and outbound dialing functionality in the accounts receivable management vertical, and we believe this acquisition will expand our global customer base and provide complementary solutions. We will offer the Latitude software suite as a standalone solution, which will include integration with our Interaction Dialer (R) application, as well as with other third-party dialer products.

Financial Highlights

The table below shows our total revenues (in millions) for the most recent five quarters and the years ended December 31, 2009, 2008 and 2007 and the percentage change over the previous period.

Period	Revenues		Sequential Growth %
Three Months Ended:
September 30, 2010	$	41.8		8	%
June 30, 2010		38.8		11	%
March 31, 2010		35.0		(3	)%
December 31, 2009		35.9		8	%
September 30, 2009		33.2		1	%

Year Ended December 31:
2010 year-to-date (9 months vs. 9 months)	$	115.7		21	%
2009		131.4		8	%
2008		121.4		10	%
2007		109.9		32	%

During the three and nine months ended September 30, 2010 product revenues increased 32% and 21%, respectively, compared to the same periods in 2009. These increases were primarily due to an increase in the average transaction value received as we continue to license our software to larger organizations through both our partner channels and direct sales force. Hardware revenues also increased as an increased number of transactions also included sales of our media servers and gateways consistent with selling larger systems.

Our CaaS revenues have continued to grow throughout 2010, with an increase in CaaS revenues for the three and nine months ended September 30, 2010 of 90% and 80%, respectively, compared to the same periods in 2009. Interest for our hosted solution continues to grow among current and prospective customers as cloud computing is growing as an accepted alternative to premise-based solutions. Additionally, unlike offerings from our competitors, our solution allows customers to keep their voice traffic and data on their own network. Moreover, our ability to offer both a premise-based and hosted solution enables us to market our solutions to a wider range of customers than our competitors.

As our CaaS business grows, the associated costs have also increased as we expand our CaaS infrastructure both domestically and internationally. Currently, we have operations in two data centers in the United States and one in the United Kingdom and are establishing operations in three additional countries.

During the third quarter of 2010, our professional services commitments increased as we received over $6.0 million in professional services orders, which will be recognized in future periods as the work is completed, compared to between $2 million and $3 million of commitments historically received in any one quarter. This increase was attributable to both the larger contracts from premise-based customers and CaaS transactions.

During the three and nine months ended September 30, 2010, we continued to invest in our operations by increasing our staffing company-wide by 19%, which resulted in increased compensation expenses and recruiting costs. We anticipate our staffing levels will continue to increase.

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, 2010 and 2009 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,
	2010			2009			2010			2009
Revenues:
Product		49	%		47	%		47	%		47	%
Services		51			53			53			53
Total revenues		100			100			100			100
Cost of revenues:
Product		15			12			14			13
Services		16			17			16			17
Total cost of revenues		31			29			30			30
Gross profit		69			71			70			70
Operating expenses:
Sales and marketing		29			29			29			30
Research and development		18			18			18			18
General and administrative		10			11			10			11
Total operating expenses		56			58			57			59
Operating income		13			13			13			10
Other income (expense):
Interest income, net		--			--			--			--
Other income (expense), net		1			1			(1	)		1
Total other income		1			1			(1	)		1
Income before income taxes		14			14			12			11
Income tax expense		6			6			5			5
Net income		8	%		8	%		7	%		6	%

Comparison of Three and Nine Months Ended September 30, 2010 and 2009

Revenues

Primary Sources of Revenues

We generate revenues from: (i) product revenues, which include licensing the right to use our software applications and, in certain instances, selling hardware as a part of our solutions; and (ii) services revenues, which include support fees from perpetual license agreements, renewal fees from annually renewable license agreements, professional services fees, educational services fees, and fees from our CaaS offering. Our revenues are generated by direct sales to customers and through our partner channels.

Product Revenues	Three Months Ended September 30,						Nine Months Ended September 30,
	2010			2009			2010			2009
	($ in thousands)
Product revenues	$	20,586		$	15,557		$	54,484		$	45,100
Change from prior year period		32	%		6	%		21	%		1	%
Percentage of total revenues		49	%		47	%		47	%		47	%

Not all software and hardware product orders are recognized as revenues when they are received because of certain contractual terms or the collection history with particular customers or partners. Consequently, product revenues for any particular period not only reflect certain of the orders received in the current period but also certain orders received in previous periods and recognized in the current period. In addition, product orders include maintenance and support, which is deferred and recognized over the maintenance and support period.

Product revenues increased by $5.0 million, or 32%, during the three months ended September 30, 2010 compared to the same period in 2009. This increase was primarily due to a 54% increase in the dollar amount of product orders received from both new and existing customers. The increase in the dollar amount of orders was experienced across all three major geographic regions in which we operate. In addition, we received 20 product orders greater than $250,000 during the quarter, with six orders greater than $1.0 million. This compared to 10 orders greater than $250,000 during the same quarter in 2009 with two orders greater than $1.0 million. Finally, the amount of hardware revenue increased 67% during the quarter compared to the same period a year ago.

Product revenues increased by $9.4 million, or 21%, during the nine months ended September 30, 2010 compared to the nine months ended September 30, 2009 primarily due to a 28% increase in the dollar amount of product orders received from both new and existing customers. The increase in the dollar amount of orders was experienced in all three major geographic regions in which we operate. In addition, during the nine months ended September 30, 2010, we received 47 orders greater than $250,000, including nine orders greater than $1.0 million, compared to 33 orders received greater than $250,000 during the nine months ended September 30, 2009, including five orders greater than $1.0 million. The amount of hardware revenue also increased 44% compared to the nine months ended September 30, 2009.

Product revenues can fluctuate from period to period depending on the mix of contracts sold between perpetual and annually renewable licenses. While the majority of our product licenses are perpetual, we have certain customers, whose original contracts were signed prior to 2004, with renewable term licenses. Generally, orders for perpetual licenses result in a significant portion of the contract value being recognized when received if recognition criteria are satisfied, while renewable term licenses are recognized ratably over the term of the agreement, generally one year. The impact of the mix of contracts on our product revenues occurs only in the year of a product order; subsequent renewal fees received for annually renewable licenses and renewal support fees for perpetual contracts are all allocated entirely to services revenues.

Services Revenues	Three Months Ended September 30,						Nine Months Ended September 30,
	2010			2009			2010			2009
	($ in thousands)
Services revenues	$	21,245		$	17,613		$	61,181		$	50,441
Change from prior year period		21	%		15	%		21	%		11	%
Percentage of total revenues		51	%		53	%		53	%		53	%

Services revenues include the portion of license arrangements allocated to maintenance and support from perpetual and annually renewable contracts, renewals of annually renewable licenses and maintenance contracts, and revenues from professional services, CaaS and education. Revenues related to our renewal and support fees represented 71% and 73% our total services revenues for the three and nine months ended September 30, 2010, respectively, and 77% of our total services revenues for both the three and nine months ended September 30, 2009. 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. Renewal rates for license and support fees in the three and nine months ended September 30, 2010 were consistent with prior periods.

Services revenues increased by $3.6 million during the three months ended September 30, 2010 compared to the same period in 2009 primarily due to increased maintenance and support fees of $1.5 million, professional services fees of $1.2 million and CaaS revenues of over $600,000. The increase in maintenance and support fees resulted from continued growth in the number and size of our installed base of customers. Professional services increased due to larger customer installations and CaaS revenues increased as more customers elected cloud-based instead of premise-based solutions.

Services revenues increased by $10.7 million during the nine months ended September 30, 2010 compared to the same period in 2009 primarily due to increased maintenance and support fees of $6.0 million, professional services fees of $2.1 million and CaaS revenues of $1.8 million. The increase in maintenance and support fees as well as professional services resulted from continued growth in our installed base of customers, and the increase in CaaS revenues resulted from an increased number of customers choosing a cloud solution. We believe our installed base of customers and resulting revenues will continue to grow.

Revenues from CaaS contracts are recognized ratably over the life of the contract, which is typically three to four years. Our unrecognized CaaS revenues increased to $13.6 million as of September 30, 2010 as we signed new CaaS contracts as more customers are showing interest in hosted solutions. This amount is not included in deferred revenue shown on our balance sheet. Although some costs related to CaaS are fixed, others are variable based on usage and call volume, and therefore, we would expect our services expenses to increase as the revenues from these orders are recognized. We believe our CaaS services revenues will continue growing as more customers utilize hosted delivery of software for their information technology needs.

Cost of Revenues	Three Months Ended September 30,						Nine Months Ended September 30,
	2010			2009			2010			2009
	($ in thousands)
Cost of revenues:
Product	$	6,198		$	3,950		$	16,499		$	12,320
Services		6,767			5,549			18,552			16,758
Total cost of revenues	$	12,965		$	9,499		$	35,051		$	29,078
Change from prior year period		36	%		(3	)%		21	%		1	%
Product costs as a % of product revenues		30	%		25	%		30	%		27	%
Services costs as a % of services revenues		32	%		32	%		30	%		33	%

Cost of product consists of hardware costs (including media servers and Interaction Gateway appliances that we develop, as well as servers, telephone handsets and gateways that we purchase and resell), royalties for third-party software and other technologies included in our solutions, personnel costs and product distribution facility costs. Cost of product can fluctuate depending on which software applications are licensed to our customers and partners, 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 and appliances.

Cost of product increased $2.2 million and $4.2 million during the three and nine months ended September 30, 2010, respectively, compared to the same periods in 2009 primarily as more customers purchased our hardware offerings to implement their solutions. In addition, during the three and nine months ended September 30, 2010 compared to the three and nine months ended September 30, 2009, royalty expense increased $684,000 and $957,000, respectively, principally due to a contractual commitment.

Cost of services consists primarily of compensation expenses for technical support, professional services and educational personnel as well as costs associated with our CaaS offering. Cost of services increased by $1.2 million during the three months ended September 30, 2010 compared to the same period in 2009, primarily due to increased compensation expense of $696,000 and increased travel expense of $285,000 resulting from an increase in services delivered on-site at customers’ locations. CaaS related expenses also increased by $298,000 due to increased data center and associated hosting costs.

Cost of services increased by $1.8 million during the nine months ended September 30, 2010 compared to the same period in 2009 primarily due to increased compensation expense of $1.3 million and travel expense of $461,000 resulting from an increase in services delivered on-site at customers’ locations. In addition, CaaS related expenses increased by $987,000 due to increased data center and associated hosting costs. Partially offsetting these increases was a decrease during the nine months ended September 30, 2010 compared to the same period in 2009 in expenses related to employee incentives of $281,000 as well as CaaS professional services costs of $611,000 which were deferred and will be recognized ratably over the life of the related CaaS contract.

Gross Profit	Three Months Ended September 30,						Nine Months Ended September 30,
	2010			2009			2010			2009
	($ in thousands)
Gross profit	$	28,866		$	23,671		$	80,614		$	66,463
Change from prior year period		22	%		17	%		21	%		8	%
Percentage of total revenues		69	%		71	%		70	%		70	%

Gross profit increased by $5.2 million and $14.2 million, respectively, during the three and nine months ended September 30, 2010 compared to the same periods in 2009 as a result of the impact of the factors discussed above.

Operating Expenses

Sales and Marketing	Three Months Ended September 30,						Nine Months Ended September 30,
	2010			2009			2010			2009
	($ in thousands)
Sales and marketing expenses	$	12,106		$	9,696		$	33,939		$	28,877
Change from prior year period		25	%		2	%		18	%		(3	)%
Percentage of total revenues		29	%		29	%		29	%		30	%
Percentage of net product revenues		84	%		84	%		89	%		88	%

Sales and marketing expenses primarily include compensation, travel, and promotional costs related to our sales, marketing and channel management operations. These expenses increased by $2.4 million and $5.1 million during the three and nine months ended September 30, 2010, respectively, compared to the same periods in 2009 primarily due to increases in compensation expense of $1.2 million and $2.8 million, respectively, and travel and entertainment expenses of $146,000 and $477,000, respectively, as sales and marketing staffing increased 15% compared to a year ago. In addition, corporate marketing expenses increased for the three and nine months ended September 30, 2010 by $449,000 and $950,000, respectively, as we expanded our promotional and branding initiatives and by $360,000 and $409,000, respectively, as we paid more to third parties for customer order referrals.

Research and Development	Three Months Ended September 30,						Nine Months Ended September 30,
	2010			2009			2010			2009
	($ in thousands)
Research and development expenses	$	7,193		$	6,135		$	20,562		$	17,747
Change from prior year period		17	%		6	%		16	%		10	%
Percentage of total revenues		17	%		18	%		18	%		19	%

Research and development expenses are comprised primarily of compensation and depreciation expenses. These expenses increased by $1.1 million and $2.8 million during the three and nine months ended September 30, 2010, respectively, compared to the same periods in 2009 primarily due to an increase in compensation expense of $980,000 and $2.6 million, respectively, resulting from an 18% increase in research and development staffing.

We believe that investment in research and development is critical to our future growth, particularly because our competitive position in the marketplace is directly related to the timely development of new and enhanced solutions. As a result, we expect research and development expenses will continue to increase in future periods.

General and Administrative	Three Months Ended September 30,						Nine Months Ended September 30,
	2010			2009			2010			2009
	($ in thousands)
General and administrative expenses	$	3,960		$	3,562		$	11,859		$	10,166
Change from prior year period		11	%		5	%		17	%		(9	)%
Percentage of total revenues		9	%		11	%		10	%		11	%

General and administrative expenses include salary and incentive compensation expense as well as 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 by $398,000 and $1.7 million during the three and nine months ended September 30, 2010, respectively, compared to the same periods in 2009. These increases were primarily due to an increase in compensation expense of $216,000 and $679,000, respectively, primarily related to a staffing increase of 18%. Bad debt expense also increased by $467,000 during the 2010 nine month period compared to the same period in 2009.

Other Income (Expense)

Interest Income, Net	Three Months Ended September 30,						Nine Months Ended September 30,
	2010			2009			2010			2009
	($ in thousands)
Cash, cash equivalents and short-term investments (average)	$	80,538		$	57,031		$	75,255		$	52,760
Interest income		120			50			228			232
Return on investment (annualized)		0.60	%		0.35	%		0.40	%		0.59	%

Interest income, net, primarily consists of interest earned from investments and interest-bearing cash accounts. Interest expense and fees, which are not material for any years reported, are also included in this category.

Interest earned on investments increased during the three and nine months ended September 30, 2010 compared to the three and nine months ended September 30, 2009 as a result of higher interest rates from increasing interest yields on investments. During the first quarter of 2010, we held the majority of our liquid investments in money market funds that are secured by low risk government securities. During the second and third quarters of 2010, as interest rates began to rise, we purchased additional corporate notes which increased our return on investment.

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 do not have any investments in subprime assets.

Other Income (Expense), Net	Three Months Ended September 30,				Nine Months Ended September 30,
	2010		2009		2010			2009
	($ in thousands)
Other income (expense), net	$	337	$	480	$	(1,029	)	$	706

Other income (expense), net includes foreign currency transaction gains and losses. These gains and losses can fluctuate based on the amount of receivables that are generated in certain international currencies (particularly the Euro), the exchange gain or loss that results from foreign currency disbursements and receipts, and the cash balances and exchange rates at the end of a reporting period. Other income (expense) during the three and nine months ended September 30, 2010 included $337,000 of foreign currency gains and $1.0 million of foreign currency losses, respectively. Other income during the three and nine months ended September 30, 2009 included $480,000 and $706,000, respectively, of foreign currency gains. The income during the third quarter of 2010 reflected the strengthening of the Euro and British Pound compared to the U.S. dollar during the quarter. However, year-to-date expense shows an overall weakening of the Euro and British Pound in relation to the U.S. dollar. During February 2010, we transferred the majority of our Euro cash balances to a U.S. dollar account and in May 2010, we instituted a currency hedging program to help mitigate future effects of fluctuations in the foreign exchange rates on cash and receivables. We continue to explore ways to mitigate the impact of currency fluctuations in the future.

Income tax expense	Three Months Ended September 30,				Nine Months Ended September 30,
	2010		2009		2010		2009
	($ in thousands)
Income tax expense	$	2,561	$	2,005	$	5,627	$	4,488

For the three and nine months ended September 30, 2010, we expect to pay $151,000 and $431,000, respectively, for state and foreign taxes and expect to utilize our deferred tax assets to offset much of our federal tax expense. We have significant remaining credits and losses to offset taxable income and taxes payable as described in Note 8 of Notes to Condensed Consolidated Financial Statements in Part I, Item 1 of this Quarterly Report on Form 10-Q.

Our effective tax rate for the three months ended September 30, 2010 was 42.2%. This tax rate was determined by considering the annual expected federal tax rate, rates in various states and international jurisdictions in which we have operations, and a portion of the amount of stock-based compensation that is not deductible for income tax purposes.

Liquidity and Capital Resources

We generate cash from the collections related to licensing our products as well as from selling hardware, renewals of annual licenses and maintenance and support agreements, and the delivery of other services. During the first nine months of 2010, we also received $1.8 million in cash from employees exercising stock options and $261,000 from purchases of common stock under our 2000 Employee Stock Purchase Plan. We use cash primarily for paying our employees (including salaries, commissions and benefits), leasing office space, paying travel expenses, marketing activities, paying vendors for hardware, other services and supplies, and purchasing property and equipment. We expect our capital expenditures to total approximately $4.1 million in 2010 primarily for purchases of furniture and equipment and leasehold improvements.

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 and current or expected obligations associated with our operations over the next 12 months. Our future requirements will depend on many factors, including cash flows from operations, territory expansion and product development decisions and potential acquisitions. If our liquidity is not sufficient to cover our needs, we may be forced to raise additional capital, either through the capital markets or debt financings, and may not be able to do so on favorable terms or at all.

	September 30, 2010		December 31, 2009
	($ in thousands)
Cash and cash equivalents	$	49,688	$	48,497
Short-term investments		35,842		16,482
Total liquidity	$	85,530	$	64,979

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 investments is reported as a source of cash. Subsequent to September 30, 2010, we utilized cash on hand to acquire Latitude for $14.0 million, which is not reflected in the table above.

The following table shows cash flows from operating activities, investing activities and financing activities for the stated periods:

	Nine Months Ended September 30,
	2010			2009

Beginning cash and cash equivalents	$	48,497		$	34,705
Cash provided by operating activities		17 , 225			13,038
Cash (used in) provided by investing activities		(22,653	)		(1,974	)
Cash provided by financing activities		6 , 619			4,815
Ending cash and cash equivalents	$	49,688		$	50,584

Cash provided by operating activities during both periods was generated primarily by our net income adjusted for routine fluctuations in our operating assets and liabilities. The cash used in investing activities during the nine months ended September 30, 2010 increased as we transferred a portion of our cash to short-term investments as the interest rates improved. Cash provided by financing activities during both periods was due to tax benefits from stock-based payment arrangements and proceeds from stock options exercised.

Contractual Obligations

As of March 31, 2010, we had additional purchase obligations totaling $297,000 to be paid out over the next year related to the build-out of on-site employee dining at our world headquarters. As of September 30, 2010, approximately $148,000 had been paid. Subsequent to September 30, 2010, the remaining amount of this contractual obligation was paid. There have been no other material changes to 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, 2009.

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, 2009, 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, 2010.

We provide indemnifications of varying scope and amount to certain customers against claims of intellectual property infringement made by third parties arising from the use of our products. Our software license agreements, in accordance with FASB ASC Topic 460, Guarantees , include certain provisions for indemnifying customers, in material compliance with their license agreement, against liabilities if our software products infringe upon a third party's intellectual property rights, over the life of the agreement. We are not able to estimate the potential exposure related to the indemnification provisions of our license agreements but have not incurred expenses under these indemnification provisions. We may at any time and at our option and expense: (i) procure the right of the customer to continue to use our software that may infringe a third party’s rights; (ii) modify our software so as to avoid infringement; or (iii) require the customer to return our software and refund the customer the fee actually paid by the customer for our software less depreciation based on a five-year straight-line depreciation schedule. The customer’s failure to provide timely notice or reasonable assistance will relieve us of our obligations under this indemnification to the extent that we have been actually and materially prejudiced by such failure. To date, we have not incurred, nor do we expect to incur, any material related costs and, therefore, have not reserved for such liabilities.

Our software license agreements also include a warranty that our software products will substantially conform to our software user documentation for a period of one year, provided the customer is in material compliance with the software license agreement. To date, we have not incurred any material costs associated with these product warranties, and as such, we have not reserved for any such warranty liabilities in our operating results.

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, revenues 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, 2009 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, 2009. 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 market risks, including changes in foreign currency exchange rates, interest rates or weak economic conditions in certain markets. Market risk is the potential of loss arising from unfavorable changes in market rates and prices.

Foreign Currency Exchange Rates

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 U.S. dollars, a strengthening of the U.S. 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. In May 2010, we began hedging our Euro cash and accounts receivable balances. The volatility of exchange rates and our increasing balances outstanding overseas have resulted in us continuing to explore ways to better mitigate the impact of currency fluctuations in the future. We continue to attempt to mitigate our foreign currency risk by generally transacting business and paying salaries in the local 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. If this were to occur, foreign currency fluctuations would have a greater impact on us and may have an adverse effect on our results of operations. For the three months ended September 30, 2010, our foreign currency transaction gains equaled $337,000 and for the nine months ended September 30, 2010, our foreign currency transaction losses equaled $1.0 million.

As of September 30, 2010 and December 31, 2009, we had cash accounts with Euro balances of approximately $3.3 million and $14.6 million, respectively, British Pound balances of $157,000 and $289,000, respectively, and balances of seven other foreign currencies totaling $497,000 and $371,000, respectively. During the first quarter of 2010, we converted the majority of our Euro and British Pound balances back to U.S. dollars in order to reduce foreign currency risk. During the second quarter of 2010 we began hedging Euro cash and accounts receivable balances to reduce foreign currency risk.

Interest Rate Risk

We invest cash balances in excess of operating requirements in securities that 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 Exchange Act is (a) recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and (b) accumulated and communicated to our management, including our principal executive and principal financial officers, to allow timely decisions regarding required disclosures. 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, 2010, pursuant to Rule 13a-15 of the Exchange Act. Based on that evaluation, our President and Chief Executive Officer and our Chief Financial Officer concluded that our disclosure controls and procedures were effective as of September 30, 2010.

There have been no changes in our internal control over financial reporting that occurred during the quarter ended September 30, 2010 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 under “Legal Proceedings” in Note 7 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 Part I, Item 1A “Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2009. 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. There have been no material changes from the risk factors previously disclosed in our Annual Report on Form 10-K for the year ended December 31, 2009.

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

7/28/2009

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 9, 2010	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)