INTERACTIVE INTELLIGENCE INC
10-Q, 2000-08-11
PREPACKAGED SOFTWARE
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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

(Mark One)  
/x/ QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the quarterly period ended June 30, 2000
 
/ /		  
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
(IRS Employer Identification No.)

8909 Purdue Road
Suite 300
Indianapolis, Indiana 46268
(Address of principal executive offices)

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

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

Yes   X    No      

    The number of shares of common stock outstanding on July 31, 2000 was 14,268,319.


TABLE OF CONTENTS

 
    
   PAGE NO.
PART I. FINANCIAL INFORMATION    
 
Item 1.		  
 		  
Condensed Consolidated Balance Sheets as of June 30, 2000 and December 31, 1999		  
 		  
1
 
 		  
 		  
Condensed Consolidated Statements of Operations for the three and six months ended June 30, 2000 and 1999		  
 		  
2
 
 		  
 		  
Condensed Consolidated Statements of Cash Flows for the six months ended June 30, 2000 and 1999		  
 		  
3
 
 		  
 		  
Notes to Condensed Consolidated Financial Statements		  
 		  
4
 
Item 2.		  
 		  
Management's Discussion and Analysis of Financial Condition and Results of Operations		  
 		  
7
 
Item 3.		  
 		  
Qualitative and Quantitative Disclosure About Market Risk		  
 		  
20
 
PART II. OTHER INFORMATION		  
 		  
 
 
Item 1.		  
 		  
Legal Proceedings		  
 		  
21
 
Item 2.		  
 		  
Changes in Securities and Use of Proceeds		  
 		  
21
 
Item 4.		  
 		  
Submission of Matters to a Vote of Security Holders		  
 		  
21
 
Item 6.		  
 		  
Exhibits and Reports on Form 8-K		  
 		  
22
 
 		  
 		  
Signature		  
 		  
23
 
 		  
 		  
 		  
 		  
 

PART I. FINANCIAL INFORMATION

Item 1.  Condensed Consolidated Financial Statements and Footnotes.

Interactive Intelligence, Inc.

Condensed Consolidated Balance Sheets

(in thousands, except share amounts)

 
   June 30,
2000
   December 31,
1999
  
 
   (Unaudited)

   (Note 1)

  
Assets  
Current assets:              
  Cash and cash equivalents   $ 2,035   $ 2,235  
  Short-term investments     10,392     12,141  
  Accounts receivable, net of allowance for doubtful accounts accounts of $393 in 2000 and $437 in 1999     5,269     3,578  
  Prepaid expenses     569     513  
  Other current assets     68     80  
   
 
 
Total current assets     18,333     18,547  
 
Property and equipment, net		  
 		  
 		  
6,531		  
 		  
 		  
4,472		  
 
Long-term investments     5,964     8,989  
Other assets, net     545     362  
   
 
 
Total assets   $ 31,373   $ 32,370  
       
 
 
 
 Liabilities and shareholders' equity		  
 
Current liabilities:              
  Accounts payable and accrued liabilities   $ 2,688   $ 1,806  
  Accrued compensation and related expenses     413     484  
  Deferred revenue     6,364     4,988  
  Current portion of capital lease obligations     505     560  
   
 
 
Total current liabilities     9,970     7,838  
Capital lease obligations, net of current portion     122     377  
Shareholders' equity:              
  Preferred stock, no par value; 10,000,000 authorized;
no shares issued and outstanding		     —     —  
  Common stock, $0.01 par value; 100,000,000 authorized;
14,225,276 issued and outstanding at June 30, 2000,
13,831,486 issued and outstanding at December 31, 1999		     142     138  
  Additional paid-in capital     46,285     45,775  
  Accumulated deficit     (25,146 )   (21,758 )
   
 
 
Total shareholders' equity     21,281     24,155  
   
 
 
Total liabilities and shareholders' equity   $ 31,373   $ 32,370  
       
 
 

See accompanying notes.

1

Interactive Intelligence, Inc.

Condensed Consolidated Statements of Operations (unaudited)

(in thousands, except per share amounts)

 
   Three months ended
June 30,
   Six months ended
June 30,
  
 
   2000
   1999
   2000
   1999
  
Revenues:                          
  Software   $ 6,279   $ 3,110   $ 11,225   $ 5,482  
  Services     2,339     1,179     4,433     1,826  
   
 
 
 
 
Total revenues     8,618     4,289     15,658     7,308  
Costs and expenses:                          
  Costs of software     134     36     197     60  
  Costs of services     2,290     1,292     4,216     2,360  
  Sales and marketing     4,340     2,462     7,862     4,553  
  Research and development     2,563     1,641     4,833     3,004  
  General and administrative     1,288     628     2,432     1,135  
   
 
 
 
 
Total costs and expenses     10,615     6,059     19,540     11,112  
   
 
 
 
 
Operating loss     (1,997 )   (1,770 )   (3,882 )   (3,804 )
 
Interest income (expense), net		  
 		  
 		  
293		  
 		  
 		  
(209		  
)		  
 		  
574		  
 		  
 		  
(398		  
)
   
 
 
 
 
Loss before income taxes     (1,704 )   (1,979 )   (3,308 )   (4,202 )
Income taxes     43     —     80     —  
   
 
 
 
 
Net loss   $ (1,747 ) $ (1,979 ) $ (3,388 ) $ (4,202 )
       
 
 
 
 
Net loss per share:                          
Basic and diluted   $ (0.12 ) $ (0.19 ) $ (0.24 ) $ (0.40 )
       
 
 
 
 
Shares used to compute net loss per share:                          
Basic and diluted     14,155     10,657     14,043     10,538  

See accompanying notes.

2

Interactive Intelligence, Inc.

Condensed Consolidated Statements of Cash Flows (unaudited)

(in thousands)

 
   Six months ended
June 30,
  
 
   2000
   1999
  
Operating activities              
Net loss   $ (3,388 ) $ (4,202 )
Adjustments to reconcile net loss to net cash used by operating activities:              
  Depreciation     1,220     661  
  Amortization of deferred stock-based compensation     42     19  
  Changes in operating assets and liabilities:              
    Accounts receivable     (1,691 )   (323 )
    Prepaid expenses     (56 )   (53 )
    Other current assets     12     (29 )
    Accounts payable and accrued liabilities     882     222  
    Accrued compensation and related expenses     (71 )   471  
    Deferred revenue     1,376     1,576  
    Accounts payable and deferred compensation—shareholder     —     (34 )
   
 
 
Net cash used by operating activities     (1,674 )   (1,692 )
Investing activities              
Purchases of property and equipment, net     (3,279 )   (1,730 )
Purchases of available-for-sale investments     (2,190 )   —  
Sales of available-for-sale investments     6,964     —  
Change in other assets     (183 )   (19 )
   
 
 
Net cash provided (used) by investing activities     1,312     (1,749 )
Financing activities              
Borrowings under lines of credit     —     1,055  
Principal payments on capital lease obligations     (310 )   (265 )
Repayments under notes payable and accrued interest—shareholder     —     461  
Proceeds from issuances of common stock     —     120  
Repurchases of common stock     —     (10 )
Proceeds from stock options exercised     472     146  
   
 
 
Net cash provided by financing activities     162     1,507  
   
 
 
Net decrease in cash and cash equivalents     (200 )   (1,934 )
Cash and cash equivalents, beginning of period     2,235     2,021  
   
 
 
Cash and cash equivalents, end of period   $ 2,035   $ 87  
       
 
 

See accompanying notes.

3

Interactive Intelligence, Inc

Notes to Condensed Consolidated Financial Statements

(Unaudited)

1.  Description of Business and Basis of Presentation

2.  Net Loss Per Common Share

4

 
   Three Months Ended
June 30,
   Six Months Ended
June 30,
  
 
   2000
   1999
   2000
   1999
  
Net Loss:   $ (1,747 ) $ (1,979 ) $ (3,388 ) $ (4,202 )
     
 
 
 
 
Basic and Diluted:                          
Weighted-average shares used to compute loss per share     14,155     10,657     14,043     10,538  
     
 
 
 
 
Basic and diluted net loss per common share   $ (0.12 ) $ (0.19 ) $ (0.24 ) $ (0.40 )
     
 
 
 
 

3.  Bank Lines of Credit

4.  Contingencies

5

6

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

Forward-Looking Information

    Certain statements in this Form 10-Q contain "forward-looking" information (as defined in Section 27A of the Securities Act of 1933, as amended) that involve risks and uncertainties which may cause actual results to differ materially from those predicted in the forward-looking statements. Forward-looking statements can be identified by their use of such verbs as "expects," "anticipates," and "believes" or similar verbs or conjugations of such verbs. If any of our assumptions on which the statements are based prove incorrect or should unanticipated circumstances arise, our actual results could materially differ from those anticipated by such forward-looking statements. The differences could be caused by a number of factors or combination of factors, including, but not limited to, the "Factors Affecting Operating Results" described herein and the Risk Factors described in our Securities and Exchange Commission filings, including the Form 10-K filing for the year ended December 31, 1999.

Overview

    We commenced operations in October 1994. Through the end of 1996, we focused primarily on research and development activities. EIC was released in March 1997. In 1997 and 1998, we expanded our operations to capitalize on the increased market demand for communications and interaction management software. We decided, at the expense of profitability, to continue investing significantly in research and development, and to accelerate our investments in marketing, services and sales operations. We had no revenue in 1996, and our total revenues were $1.6 million in 1997, $9.0 million in 1998 and $19.1 million in 1999. Through the six months ended June 30, 2000, our total revenues were $15.7 million.

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

Historical Results of Operations

    The following table presents certain financial data, derived from our unaudited statements of operations, as a percentage of total revenues for the periods indicated. The operating results for the

7

three and six months ended June 30, 2000 and 1999 are not necessarily indicative of the results that may be expected for the full year or for any future period.

 
   Three months ended
June 30,
   Six months ended
June 30,
  
 
   2000
   1999
   2000
   1999
  
Revenues:                  
  Software   73 % 73 % 72 % 75 %
  Services   27   27   28   25  
   
 
 
 
 
Total revenues   100   100   100   100  
   
 
 
 
 
Costs and expenses:                  
  Costs of software   2   1   1   1  
  Costs of services   26   30   27   32  
  Sales and marketing   50   57   50   62  
  Research and development   30   38   31   41  
  General and administrative   15   15   16   16  
   
 
 
 
 
Total costs and expenses   123   141   125   152  
   
 
 
 
 
Operating loss   (23 ) (41 ) (25 ) (52 )
Interest income (expense), net   3   (5 ) 4   (5 )
   
 
 
 
 
Loss before income taxes   (20 ) (46 ) (21 ) (57 )
Income taxes   0   0   1   0  
   
 
 
 
 
Net loss   (20 )% (46 )% (22 )% (57 )%
       
 
 
 
 

Revenues

    Our total revenues increased 101% from $4.3 million for the three months ended June 30, 1999 to $8.6 million for the three months ended June 30, 2000. Total revenues increased 114% from $7.3 million for the six months ended June 30, 1999, to $15.7 million for the six months ended June 30, 2000. Non-North American revenues grew from $741,000 and $1.4 million for the three and six months ended June 30, 1999 respectively, to $1.5 million and $3.5 million for the three and six months ended June 30, 2000 respectively. Our revenues are derived primarily from license fees and charges for services, including product maintenance, education services, and professional services. The increase in total revenues resulted primarily from increases in the number of both new and existing software licenses and, to a lesser extent, product maintenance revenues. We do not believe that the percentage increases in revenues achieved in prior periods should be anticipated in future periods. We anticipate that software revenues will continue to represent the majority of our revenues for the foreseeable future.

    Software.  Our software revenues increased 102% from $3.1 million for the three months ended June 30, 1999, to $6.3 million for the three months ended June 30, 2000. Software revenues increased 105% from $5.5 million for the six months ended June 30, 1999, to $11.2 million for the six months ended June 30, 2000. The increase in software revenues can be attributed to an increase in EIC licenses as a result of the July 1999 release of EIC Version 1.3, increased market acceptance for EIC and other products, and a growing geographic presence in North America, Europe, and the Asia/Pacific region.

    Services.  Services revenues increased 98% from $1.2 million for the three months ended June 30, 1999, to $2.3 million for the three months ended June 30, 2000. Services revenues increased 143% from

8

$1.8 million for the six month period ended June 30, 1999, to $4.4 million for the six month period ended June 30, 2000. The increase in services revenue was primarily due to an increase in product maintenance revenues, which is related to our growing installed base of end-user customers. We also realized additional education revenues and additional implementation and customization revenues from our professional services organization.

Cost and Expenses

    Our total costs and expenses increased 75% from $6.1 million for the three months ended June 30, 1999, to $10.6 million for the three months ended June 30, 2000. Similarly, total costs and expenses increased 76% from $11.1 million for the six months ended June 30, 1999, to $19.5 million for the six months ended June 30, 2000. The increase in amount was primarily due to increases in investments in our research and development, marketing, and sales and services efforts.

    Costs of Software.  Costs of software consist primarily of product royalties paid to third-parties for the use of their technologies in our products and, to a lesser extent, software packaging costs, which include product media, duplication and documentation. Costs of software increased from $36,000 for the three months ended June 30, 1999, to $134,000 for the three months ended June 30, 2000. This represents 1% of software revenues for the three months ended June 30, 1999 and 2% for the three months ended June 30, 2000. Costs of software increased from $60,000 for the six months ended June 30, 1999 to $197,000 for the six months ended June 30, 2000. This represents 1% of software revenues in both periods. The increase was due to royalties owed as a result of higher software revenues and an increase in estimated royalty expenses related to third-party technology. We expect product royalties to continue to increase as we release additional products and integrate additional third-party functions and features into our product offerings.

    Costs of Services.  Costs of services consist primarily of compensation expenses for technical support, education, and professional services personnel and other costs associated with supporting our resellers and end-user customers. Costs of services increased from $1.3 million for the three months ended June 30, 1999, to $2.3 million for the three months ended June 30, 2000. Costs of services increased from $2.4 million for the six months ended June 30, 1999, to $4.2 million for the six months ended June 30, 2000. As a percentage of services revenues, cost of services represented 110% and 98% for the three months ended June 30, 1999 and 2000, respectively, and 129% and 95% for the six months ended June 30, 1999 and 2000, respectively. The increase in amount was due to an ongoing effort to maximize our reseller effectiveness and end-user customer satisfaction through the expansion of our technical support, education and professional services organizations. We expect that costs of services will increase as we make continued investments to support our end-user customer base and resellers.

    Sales and Marketing.  Sales and marketing expenses consist of trade shows, advertising, telemarketing campaigns and other promotional expenses, compensation expenses, including sales commissions, and travel expenses. Sales and marketing expenses increased from $2.5 million for the three months ended June 30, 1999, to $4.3 million for the three months ended June 30, 2000. Sales and marketing expenses increased from $4.6 million for the six months ended June 30, 1999 to $7.9 million for the six months ended June 30, 2000. The increase reflects the expansion of our worldwide sales and marketing organizations, and higher sales compensation associated with higher software revenues, and marketing activities such as trade shows and advertising. We currently plan to continue investing significantly in sales and marketing efforts.

    Research and Development.  Research and development expenses consist primarily of compensation expenses for our developers and third party efforts to develop and enhance our products, including adapting our products for specific countries. Research and development expenses increased from $1.6 million for the three months ended June 30, 1999, to $2.6 million for the three months ended

9

June 30, 2000. Research and development expenses increased from $3.0 million for the six months ended June 30, 1999, to $4.8 million for the six months ended June 30, 2000. Currently, all costs related to research and development of our products are charged to research and development expense as incurred. The dollar increases in research and development expenses were due to the hiring of software developers and third party efforts required to enhance our existing product suite, develop new products, and localize our products for the Japanese, Korean, Chinese and Spanish markets. We believe that a significant investment in research and development has been, and will continue to be, critical to market acceptance of our products.

    General and Administrative.  General and administrative expenses consist primarily of compensation for our administrative, financial, and information technology personnel, and a number of non-allocable costs, including legal and other professional service fees. General and administrative expenses increased from $628,000 for the three months ended June 30, 1999, to $1.3 million for the three months ended June 30, 2000. General and administrative expenses increased from $1.1 million for the six months ended June 30, 1999 to $2.4 million for the six months ended June 30, 2000. The increase resulted primarily from the addition of personnel to support the growth of our business and an increased amount of legal and other professional service fees. We believe our general and administrative expenses will continue to increase as we expand our administrative infrastructure and incur legal and other professional service fees.

Interest income (expense), net

    Interest income is generated primarily from invested cash from our initial public offering completed in September 1999. Interest expense is currently generated only by our capital lease lines of credit. During the three and six months ended June 30, 1999, interest expense was also generated by debt owed to our principal stockholder and various commercial lines of credit. Net interest expense was $209,000 for the three months ended June 30, 1999, while net interest income was $293,000 for the three months ended June 30, 2000. Additionally, net interest expense was $398,000 for the six months ended June 30, 1999 while net interest income was $574,000 for the six months ended June 30, 2000. The change to net interest income from net interest expense was due to investing the proceeds from our initial public offering in interest-bearing securities after repaying all outstanding debt except for our capital lease lines.

Income taxes

    For U.S. corporate income tax purposes, we did not recognize a tax benefit related to U.S. federal or state income taxes during the three months or six months ended June 30, 1999 or June 30, 2000 because of the uncertainty of eventually realizing these benefits. However, we did recognize a tax expense related to our international operations of $43,000 for the three months ended June 30, 2000, and $80,000 for the six months ended June 30, 2000. No income tax expense related to our international operations was recognized for the three or six months ended June 30, 1999.

Liquidity and Capital Resources

    In September 1999, we sold 3.0 million shares of common stock in our initial public offering, generating $39.0 million in cash, before offering expenses. As of June 30, 2000, we had cash and cash equivalents of $2.0 million, short term investments of $10.4 million, long-term investments of $6.0 million and a working capital balance of $8.4 million. Prior to our initial public offering, we funded our operations primarily through equity and debt infusions from our principal stockholder, Dr. Brown, and a $5.0 million equity investment by Dialogic Investment Corporation (now owned by Intel Corporation), and borrowings under commercial lines of credit.

10

    Our operating activities resulted in net cash outflows of $1.7 million for both the six months ended June 30, 1999 and the six months ended June 30, 2000. The operating cash outflows for the first six months of 1999 were primarily the result of our operating loss and an increase in accounts receivable, partially offset by an increase in deferred revenue. The operating cash outflows for the first six months of 2000 were also primarily the result of our operating loss, an increase in accounts receivable, partially offset by an increase in deferred revenue and the non-cash depreciation amount.

    Our investing activities have consisted primarily of capital expenditures for property and equipment, including $1.7 million and $3.3 million of capital expenditures for the six month periods ended June 30, 1999 and 2000, respectively. These capital expenditures have consisted primarily of computer hardware, software, office equipment, and furniture for our growing employee headcount, and our research and development needs. At June 30, 2000, we did not have any material commitments for future capital expenditures.

    Prior to the initial public offering, financing activities consisted primarily of the issuance of debt and equity to Dr. Brown, borrowings under commercial lines of credit, and the equity investment by Dialogic Investment Corporation (now owned by Intel Corporation). For the six months ended June 30, 1999 we generated $1.5 million in net proceeds from financing activities which included issuances of common stock, stock options exercised and borrowing under our line of credit, partially offset by scheduled repayments of our capital lease lines. For the six months ended June 30, 2000 we generated $162,000 in net proceeds from financing activities which included stock option exercises partially offset by scheduled repayments of our capital lease lines. At June 30, 2000, we had no amounts outstanding on our commercial lines of credit totaling $5.0 million. These lines of credit expired on June 30, 2000 and were not renewed.

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

Factors affecting Operating Results

OUR LIMITED OPERATING HISTORY MAKES FINANCIAL FORECASTING DIFFICULT AND, IN ASSESSING OUR PROSPECTS, YOU SHOULD CONSIDER OUR EARLY STAGE OF DEVELOPMENT AND PRESENCE IN A NEW AND RAPIDLY EVOLVING INDUSTRY

    Our limited operating history makes it difficult to forecast our future operating results. We commenced operations in October 1994, but did not begin shipping our flagship product, Enterprise Interaction Center® or EIC, until 1997. In 1999, we began shipping Interaction Recorder™, Interaction Dialer™, and e-FAQ™. Accordingly, you should assess our prospects in light of the risks and difficulties frequently encountered by companies in the early stage of development, particularly companies in new and rapidly evolving industries.

WE HAVE HISTORICALLY INCURRED LOSSES AND WE MAY NOT ACHIEVE PROFITABILITY

    We have not operated profitably to date. We incurred net losses of $7.1 million, $7.4 million, and $5.4 million in 1999, 1998, and 1997, respectively. At June 30, 2000, we had accumulated losses since inception of $25.1 million. We intend to continue to make significant investments in our research and development, marketing, services and sales operations. We anticipate that these expenses could significantly precede any revenues generated by the increased spending. As a result, we are likely to

11

continue to experience losses and negative cash flow from operations in future calendar quarters. If we do become profitable, we may not sustain or increase our profitability.

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

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

    Because we do not know when our resellers and potential end-user customers will place orders and finalize contracts, we cannot accurately forecast our revenues and operating results for future quarters. We recognize revenues on satisfaction of the requirements of AICPA Statement of Position 97-2, which generally occurs in the same quarter that the order is received. As a result, our quarterly revenues and operating results depend primarily on the size, quantity and timing of orders received for our products during each quarter. If a large number of orders or several large orders do not occur or are deferred or delayed, our revenues in a quarter could be substantially reduced. This risk is heightened by the significant investment and executive level decision making typically involved in our end-user customers' decisions to license our products. Since a large portion of our operating expenses, including rent and salaries, is fixed and difficult to reduce or modify, our business, financial condition or results of operations could be materially adversely affected if revenues do not meet our expectations.

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

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

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

12

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

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

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

    If we are not able to manage our growth successfully, we will not grow as planned and our business could be adversely affected. We have grown total revenues to $19.1 million in 1999 from $9.0 million in 1998 and $1.6 million in 1997, and we intend to continue to grow our business operations significantly in the future. Our existing management, operational, financial and human resources and management information systems and controls may be inadequate to support our future operations. In addition, as the complexity of our product technology and our reseller and other third-party relationships have increased, the management of those relationships and the negotiation of contractual terms sufficient to protect our rights and limit our potential liabilities has become more complicated, and we expect this trend to continue in the future. As a result, our inability to successfully manage these relationships or negotiate sufficient contractual terms could have a material adverse effect on us.

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

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

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

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competitors were to acquire significant market share, it could have a material adverse effect on our business, financial condition or results of operations.

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

    Our ability to achieve revenue growth in the future will depend in part on our success in maintaining successful relationships with our existing and future resellers and OEM partners and in recruiting and training additional resellers and OEM partners. We rely primarily on resellers to market and support our products, and plan on relying more on our OEM partners in the future. We are still developing and refining our reseller and OEM distribution networks and may be unable to attract additional resellers with both voice and data expertise or appropriate OEM partners that will be able to market our products effectively and that will be qualified to provide timely and cost-effective customer support and service. We generally do not have long-term or exclusive agreements with our resellers or OEM partners, and the loss of specific larger resellers or OEM partners or a significant number of resellers or OEM partners could materially adversely affect our business, financial condition or results of operations.

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

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

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

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

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

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

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development, introduction or marketing of product enhancements, and our new products and product enhancements may not achieve market acceptance. Significant delays in the general availability of new releases of our products or significant problems in the installation or implementation of new releases of our products could have a material adverse effect on our business, financial condition or results of operations.

SLOWER THAN ANTICIPATED GROWTH IN DEMAND FOR INTERACTION MANAGEMENT SOFTWARE OF THE TYPE WE LICENSE COULD MATERIALLY ADVERSELY AFFECT OUR GROWTH PROSPECTS

    If the demand for interaction management software of the type we license does not continue to grow as anticipated within each of our four targeted markets, our ability to grow our business as planned could be materially adversely affected. All of our revenues have been generated from licenses of our EIC software or complementary products, and related support, educational and professional services. We expect these products and services to account for the majority of our revenues for the foreseeable future. Although we believe demand for the functions performed by EIC is high, and growth in demand has accelerated in recent years, particularly among call centers and e-businesses, the market for our products and services is still emerging. Further, our growth plans require us to successfully attract end-user customers in our two other target markets, enterprises and service providers, which have been much slower to adopt software technologies such as our EIC product.

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

    EIC currently serves small to medium sized call centers and enterprises with approximately 25 to 300 users at a single location. As these organizations expand to include multiple locations, EIC can be customized to increase the number of telephone lines, extensions and users. However, EIC cannot currently meet the communications needs of organizations with more than 200 users at a single call center location or 300 users at a single enterprise location. We will need to adapt our software to serve larger single-site organizations. Although we are currently developing and testing solutions that would enable our software to significantly increase the number of users that EIC can serve at a single location, we cannot assure you that we will be able to successfully introduce this technology into a currently available version of EIC. Further, we may not be able to adapt our software in a timely or cost effective manner in a way that will permit us to serve these customers. This inability could have a material adverse effect on our business, financial condition or results of operations.

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

    Dialogic Corporation is our primary supplier of the voice processing boards that are necessary for the operation of the currently available versions of our products. If Dialogic Corporation becomes unable or unwilling to continue to manufacture and supply these voice processing boards in the volume, price and technical specifications we require, then we would have to adapt our products to a substitute supplier. Although we are currently testing voice processing boards from an alternative supplier, we cannot assure you that we will be able to successfully introduce voice processing boards made by this alternative supplier into the available versions of our products. In addition, introducing a substitute supplier of voice processing boards could result in unforeseen additional product development or customization costs and could also introduce hardware and software operating or compatibility problems. These problems could affect product shipments, be costly to correct or damage our

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reputation in the markets in which we operate, and could have a material adverse affect on our business, financial condition or results of operations.

    In addition, Intel Corporation acquired Dialogic Corporation in the summer of 1999. While Intel Corporation does not currently offer a product that competes with our EIC, Intel Corporation could potentially develop a competitive or superior product or attempt to affect our current relationship with Dialogic Corporation.

    In addition, Dialogic Corporation's CT Media™ offers some of the functionality that EIC provides and consequently could make it easier for competitors or potential competitors to provide products competitive with ours. If CT Media™ were to become an industry standard, our failure to adopt it could disadvantage us in competitive situations.

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

    We regard our software products as proprietary. In an effort to protect our proprietary rights, we rely primarily on a combination of copyright, trademark and trade secret laws, as well as licensing and other agreements with consultants, suppliers, strategic partners, resellers and end-user customers, and employee and third-party non-disclosure agreements. These laws and agreements provide only limited protection of our proprietary rights. In addition, we have not signed agreements containing these types of protective provisions in every case, and the contractual provisions that are in place and the protection they provide vary and may not provide us with adequate protection in all circumstances. Although we have recently filed patent applications directed to several inventions embodied in our software products, we currently have no patents or registered copyrights. Because our means of protecting our proprietary rights may not be adequate, it may be possible for a third party to copy or otherwise obtain and use our technology without authorization. A third party could also develop similar technology independently. In addition, the laws of some countries in which we sell our products do not protect our software and intellectual property rights to the same extent as the laws of the United States. Unauthorized copying, use or reverse engineering of our products could materially adversely affect our business, results of operations or financial condition.

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

INFRINGEMENT CLAIMS COULD ADVERSELY AFFECT US

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

    In June 1999 and September 1999, the Company received letters from a competitor in the call center market claiming that the Company's products utilize technologies pioneered and patented by that competitor. The Company's patent counsel has reviewed all of the patents listed in the letters. Based on the advice of the Company's patent counsel, the Company believes that its products do not infringe any of the patents listed in either letter. The Company intends to continue to discuss its conclusion with the competitor, but cannot assure you that the competitor will concur with the

16

Company's conclusion or that this matter can be resolved amicably, without infringement claims being made by the competitor or without a material adverse effect on the Company's business, financial condition or results of operations.

    In June 2000, the Company received a letter from another competitor in the call center market suggesting that the Company's products utilize technologies pioneered and patented by that competitor. The Company's patent counsel is in the process of reviewing all of the patents listed in the letter. The Company cannot assure you that this matter can be resolved amicably, without infringement claims being made by the competitor or without a material adverse effect on the Company's business, financial condition or results of operations.

    In July 2000, the Company received a letter from a competitor in the voice processing market claiming that the Company's products utilize technologies pioneered and patented by that competitor. The Company's patent counsel is in the process of reviewing all of the patents listed in the letter. The Company cannot assure you that this matter can be resolved amicably, without further infringement claims being made by the competitor or without a material adverse effect on the Company's business, financial condition or results of operations.

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

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

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

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

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

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OUR INTERNATIONAL OPERATIONS AND EXPANSION INVOLVE FINANCIAL AND OPERATIONAL RISKS

    The expansion of our international operations will require significant management attention and financial resources to establish additional foreign operations, hire additional personnel and recruit additional international resellers. Non-North American revenues accounted for 19%, 16%, and 17% of our total revenues in 1999, 1998, and 1997, respectively. To date, our products have been licensed outside North America primarily in Western Europe, South Africa and Australia. We are also expanding our marketing efforts in Japan, Korea, China and Central and South America. We intend to continue to expand our international operations and enter additional international markets. Revenues from international expansion may be inadequate to cover the expenses of international expansion. In addition to foreign currency fluctuation risks described in Part II, Item 3, other risks inherent in our international business activities, in the countries in which we have licensed our products to date and in those countries in which we intend to expand, generally could include the following:

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

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

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

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

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

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

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

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

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

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

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communication over the Web. In addition, the Web could lose its viability due to delays in the development or adoption of new standards and protocols to handle increased activity or due to increased government regulation and taxation of Internet commerce.

ITEM 3.  Qualitative and Quantitative Disclosures About Market Risk.

    We develop products in the United States and sell licenses in North America, Europe, Asia/Pacific region, South Africa, and Central and South America. As a result, our financial results could be affected by various factors, including changes in foreign currency exchange rates or weak economic conditions in foreign markets. As all sales are currently made in U.S. dollars, a strengthening of the dollar could make our products less competitive in foreign markets.

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

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PART II. OTHER INFORMATION

Item 1.  Legal Proceedings.

    In June 1999 and September 1999, the Company received letters from a competitor in the call center market claiming that the Company's products utilize technologies pioneered and patented by that competitor. The Company's patent counsel has reviewed all of the patents listed in the letters. Based on the advice of the Company's patent counsel, the Company believes that its products do not infringe any of the patents listed in either letter. The Company intends to continue to discuss its conclusion with the competitor, but cannot assure you that the competitor will concur with the Company's conclusion or that this matter can be resolved amicably, without infringement claims being made by the competitor or without a material adverse effect on the Company's business, financial condition or results of operations.

    In June 2000, the Company received a letter from another competitor in the call center market suggesting that the Company's products utilize technologies pioneered and patented by that competitor. The Company's patent counsel is in the process of reviewing all of the patents listed in the letter. The Company cannot assure you that this matter can be resolved amicably, without infringement claims being made by the competitor or without a material adverse effect on the Company's business, financial condition or results of operations.

    In July 2000, the Company received a letter from a competitor in the voice processing market claiming that the Company's products utilize technologies pioneered and patented by that competitor. The Company's patent counsel is in the process of reviewing all of the patents listed in the letter. The Company cannot assure you that this matter can be resolved amicably, without further infringement claims being made by the competitor or without a material adverse effect on the Company's business, financial condition or results of operations.

Item 2.  Changes in Securities and Use of Proceeds.

Sales of Unregistered Securities During the Quarter

    None.

Use of Proceeds

    The shares of our common stock issued in the initial public offering were registered on a Registration Statement on Form S-1 (Registration No. 333-79509) which was declared effective on September 22, 1999. From the effective date of such Registration Statement to June 30, 2000, the proceeds generated by our initial public offering have been used as described in our report on Form 10-Q for the quarter ended September 30, 1999 and, in addition approximately $8.3 million has been used for working capital.

Item 4.  Submission of Matters to a Vote of Security Holders.

    We held our annual meeting of shareholders on May 16, 2000. At that meeting, our shareholders elected Jon Anton, D.Sc. to be a duly elected Director of the Corporation to serve a three year term or until his successor is elected and has qualified. Our shareholders also approved the adoption of the Employee Stock Purchase Plan which had been previously adopted by the Board of Directors. Finally, our shareholders approved our amended 1999 Stock Option and Incentive Plan which had been

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previously adopted by the Board of Directors. The final results of the votes taken at that meeting were as follows:

 
   Votes
For
   Votes
Against
   Broker
Non-Votes
   Abstentions
Election of Director                
  Jon Anton, D. Sc.   12,605,114   0   0   11,477
Employee Stock Purchase Plan   10,856,354   487,062   1,270,167   3,008
1999 Stock Option and Incentive Plan   10,585,503   750,825   1,270,167   10,096

    In addition, the following directors continue in office until the annual meeting of shareholders in the year indicated:

Michael P. Cullinane   2001
John R. Gibbs   2001
Donald E. Brown, M.D.   2002
Robert A. Compton   2002

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


10.3   1999 Stock Option and Incentive Plan, as amended February 22, 2000
27.1   Financial Data Schedule

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SIGNATURES

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

    INTERACTIVE INTELLIGENCE, INC.
(Registrant)
 
Date: August 11, 2000		  
 		  
By		  
/s/ MICHAEL J. TAVLIN   
Michael J. Tavlin
 Senior Vice President and Chief
Financial Officer and Secretary
(Principal Financial Officer)

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