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, 2008. The following will be discussed and analyzed:

· Forward-Looking Information

· Overview

· Financial Highlights

· Historical Results of Operations

· Liquidity and Capital Resources

· Critical Accounting Policies and Estimates

Forward-Looking Information

Certain statements in this Quarterly Report on Form 10-Q contain "forward-looking" information (as defined in the Private Securities Litigation Reform Act of 1995, Section 27A of the Securities Act of 1933, as amended and
Section 21E of the Securities Exchange Act of 1934, as amended (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 their use of such verbs as "expects", "anticipates", "believes", "intend", "plan", "may", "should", "will", "would", "will be", "will continue", "will likely result", or similar verbs or conjugations of such verbs. If any of our assumptions on which the statements are based prove incorrect or should unanticipated circumstances arise, our actual results could materially differ from those anticipated by such forward-looking statements. The differences could be caused by a number of factors or combination of factors, including, but not limited to, unstable economic conditions, rapid technological changes in the industry, our ability to maintain profitability, to manage successfully our growth, 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. ("Interactive Intelligence", "we", "us" or "our") was formed in 1994 as an Indiana corporation and maintains its world headquarters and executive offices at 7601 Interactive Way, Indianapolis, 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 for a broad range of business operations. In addition to contact centers, our solutions are used in various industries including, but not limited to, teleservices, financial services, insurance, higher education, healthcare, retail, technology, government and business services, including organizations that employ remote and mobile workers. For enterprises that rely on the Microsoft® Corporation ("Microsoft") platform, we offer a pre-integrated all-software Internet Protocol Private Branch Exchange phone and communications system that enables straightforward integration to Microsoft compatible applications for data management. In all, our innovative software products and services are designed expressly for multichannel contact management, business communications and messaging using the Session Initiation Protocol ("SIP") global communications standard that supports VoIP. To supplement our software solutions, we also offer a media server, media gateways and SIP proxy for IP-based communications networks and infrastructures. Our customers can deploy our solutions as an on-premise system at their site or as Communications as a Service ("CaaS").

Our application-based solutions are integrated on a single software platform. Overall, our platform has been developed to deliver security, broaden integration to business systems and end-user devices, enhance mobility for today's workforce, scale to thousands of users, and comprehensively address various business communications and interaction management needs in markets for:

· The Contact Center

· Enterprise IP Telephony

· Enterprise Messaging

By implementing our all-in-one solutions, businesses are able to unify multichannel communications media (phone, fax, e-mail and web chat); improve workforce performance, effectiveness and productivity; and more readily adapt to changing market and customer requirements. Organizations in the industries we serve are further able to reduce equipment and maintenance costs over traditional "multi-point" communications hardware, and additionally reduce the complexity of such non-integrated systems.

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, 2008.

We are currently completing development of the first version of Interaction Process Automation ("IPA"), an application which uses our communications-based platform to automate business processes. The IPA module integrates to and leverages the Interactive Intelligence Customer Interaction Center ("CIC") platform to automate business people-centric processes based on CIC's multichannel communications, queuing and routing capabilities. This communications-based process automation approach enables IPA to capture, prioritize, route, escalate and track each step of the process flow regardless of staff location. We are targeting general distribution of IPA by or during the first quarter of 2010. The licensing of our CIC platform is typically under a perpetual license resulting in product revenue for the license when revenue recognition criteria are met. For IPA, we currently plan on licensing for an initial one year term that will renew annually which will result in product revenue being recognized ratably over the year. We do not anticipate recognizing any revenues from the licensing of IPA until 2010.

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 and budget. Because salaries are our largest expense, we regularly monitor staffing levels. As noted below, macroeconomic conditions have materially affected the orders we received in recent quarters; therefore, we 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 to ensure we are managing new expenditures and controlling costs. Finally, management monitors diluted earnings per share, which is a key measure of performance that is also used by analysts and investors.

The table below shows our total revenues (in millions) for the most recent five quarters and the years ended December 31, 2008, 2007 and 2006 and the percentage change over the previous period.

                                          Sequential
Period                     Revenues        Growth %
Three Months Ended:
September 30, 2009        $     33.2                1 %
June 30, 2009                   32.9               12 %
March 31, 2009                  29.5               (6 )%
December 31, 2008               31.3                4 %
September 30, 2008              30.1               (2 )%

Year Ended December 31:
2008                      $    121.4               10 %
2007                           109.9               32 %
2006                            83.0               32 %

As shown in the 2008 annual growth rate and the quarterly growth rates in 2008 and 2009, our revenue growth trend has generally slowed, although we did experience significant increased growth in the second quarter of 2009. We believe that these slower growth rates are primarily due to the instability in the economy worldwide, which has resulted in longer sales cycles, as prospects are hesitant to commit to new capital purchases and many existing customers are delaying purchases of additional software and hardware as they maintain or reduce staffing levels.

We will continue to focus on maintaining profitability by continuing to increase the efficiency of our sales and marketing efforts and by management of our operating expenses. As our profitability allows, we will position the company for future growth through increased investment in research and development.

Financial Highlights

During the three and nine months ended September 30, 2009, we experienced a decrease in the dollar amount of license orders of 10% and 8%, respectively, compared to the same periods in 2008. Although total license orders decreased, product revenue increased by 6% and 1%, respectively, compared to the same periods in 2008 due to a higher percentage of perpetual contracts, which can typically be recognized immediately. In addition, during the three months ended September 30, 2009 compared to the same period in 2008, we recognized more revenues related to license orders that we had received in previous quarters but for which we had originally deferred recognition because at least one of the revenue recognition criteria had not been met.

During the three months ended September 30, 2009, we received orders for our CaaS solutions for what is contracted to be at least $3.6 million in future services revenues. The revenues from these orders will be recognized ratably over the life of the CaaS contract, which is typically three to four years. These orders represent a significant increase in CaaS contract amounts compared to those we have received in previous periods. 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 over the next three to four years.

Services revenues increased by $2.2 million and $5.1 million during the three and nine months ended September 30, 2009, respectively, compared to the same periods last year, primarily due to increased support fees as our product revenues grew and increased revenues from our CaaS related services.

Total operating expenses, which include sales and marketing, research and development and general and administrative expenses, increased by $669,000, or 4%, for the three months ended September 30, 2009 compared to the same period in 2008. Our stock-based compensation expense increased for the three months ended September 30, 2009 in part due to a reduction in the forfeiture rate assumption that we used in calculating the expense during the third quarter of 2009 based on recent history, which resulted in an increase in compensation expense for all departments during the quarter. Also impacting the quarter-over-quarter stock-based compensation expense was the reversal of some performance-based stock options in the third quarter of 2008, which reduced stock-based compensation expense in 2008. Incentive expense also increased for the three months ended September 30, 2009 as operating performance has improved and more incentives were earned. Staffing increased in the sales and marketing and research and development departments, which increased salary expense and general allocable corporate expenses. Partially offsetting these increases, travel and entertainment expenses as well as outsourced, professional and consulting services decreased during the third quarter of 2009 due to continued cost management reduction programs across all departments. Total operating expenses decreased by $344,000, or 0.6%, for the nine months ended September 30, 2009.

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, 2009 and 2008 are not necessarily indicative of the results that may be
expected for the full year or for any future period.

                                Three Months Ended           Nine Months Ended
                                   September 30,               September 30,
                               2009            2008          2009           2008
Revenues:
Product                             47 %            49 %          47 %         50 %
Services                            53              51            53           50
Total revenues                     100             100           100          100
Cost of revenues:
Product                             12              12            13           12
Services                            17              20            17           20
Total cost of revenues              29              32            30           32
Gross profit                        71              68            70           68
Operating expenses:
Sales and marketing                 29              33            30           33
Research and development            18              20            18           18
General and administrative          11              11            11           12
Total operating expenses            58              64            59           63
Operating income                    13               4            10            5
Other income:
Interest income, net                --               1            --            1
Other income, net                    1              --             1           --
Total other income                   1               1             1            1
Income before income taxes          14               5            11            6
Income tax expense                  (6 )            (2 )          (5 )         (3 )
Net income                           8 %             3 %           6 %          3 %

Comparison of Three and Nine Months Ended September 30, 2009 and 2008

Revenues

Product Revenues                  Three Months Ended           Nine Months Ended
                                     September 30,               September 30,
                                   2009          2008          2009          2008
                                                 ($ in thousands)
Product revenues                $   15,557     $ 14,687      $  45,100     $ 44,853
Change from prior year period            6 %         (5 )%           1 %          6 %
Percentage of total revenues            47 %         49 %           47 %         50 %

Product revenues, which include software, hardware and appliance revenues, increased by $870,000 during the three months ended September 30, 2009 compared to the same period in 2008. Although total license dollar orders decreased by 10% compared to the third quarter of 2008, product revenues increased by 6%. Perpetual license orders, which can typically be immediately recognized, were 92% of total license orders in the third quarter of 2009 compared to 84% in 2008. In addition, we were able to recognize certain license orders which had been received but not recognized in prior periods because all revenue recognition criteria, primarily collectability, had not been met.

Product revenues increased by $247,000 during the nine months ended September 30, 2009 compared to the same period in 2008. Although total license dollar orders decreased by 8% compared to the nine months ended September 30, 2008, product revenues increased by 1%. Perpetual license orders, which can typically be immediately recognized, were 87% of total license orders in 2009 compared to 83% in 2008. Additionally, we were able to recognize certain license orders during the nine months ended September 30, 2009 which had been received but not recognized in prior periods because all revenue recognition criteria, primarily collectability, had not been met.

Product revenues can fluctuate from period to period depending on the mix of perpetual and annually renewable licenses. The majority of our product licenses are perpetual but we do also have certain customers, whose original license 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 since fees from the subsequent renewal of annually renewable licenses and renewal of support fees for perpetual contracts are allocated entirely to services revenues.

                                  Three Months Ended          Nine Months Ended
Services Revenues                    September 30,              September 30,
                                   2009          2008         2009          2008
                                                 ($ in thousands)
Services revenues               $   17,613     $ 15,369     $  50,441     $ 45,296
Change from prior year period           15 %         12 %          11 %         19 %
Percentage of total revenues            53 %         51 %          53 %         50 %

Services revenues include the portion of license arrangements allocated to maintenance and support from annually renewable and perpetual contracts, renewals of annually renewable licenses and maintenance contracts, as well as revenues from professional services, CaaS and education.

Services revenues increased during the three and nine months ended September 30, 2009 compared to the same periods in 2008 primarily due to continued growth in the number and size of our installed base of customers. Annual license renewal fees and support fees for perpetual licenses, which comprise 77% of total services revenues, increased by $1.7 million, or 15%, and $3.6 million, or 10%, during the three months and nine months ended September 30, 2009, respectively, compared to the same periods in 2008. We believe services revenues will continue to grow as we continue to license and install our solutions to new customers and expand existing customer implementations. The actual percentage fee charged for the 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 have not materially changed in 2009.

CaaS services increased by $338,000, or 75%, and $938,000, or 67%, during the three and nine months ended September 30, 2009, respectively, compared to the same periods in 2008, as more customers chose this hosted service solution. During the third quarter of 2009, we received orders for our CaaS solutions for what is contracted to be at least $3.6 million in future revenues that will be recognized over the next three to four years. These orders did not have any impact on revenues during the three or nine months ended September 30, 2009. We believe our CaaS services revenues will continue to grow as more customers utilize outsourced services for their information technology needs instead of purchasing software and hardware and hiring additional technical employees.

                                                 Three Months Ended            Nine Months Ended
Cost of Revenues                                   September 30,                 September 30,
                                                2009            2008           2009          2008
                                                                ($ in thousands)
Cost of revenues:
Product                                      $    3,950       $   3,702     $   12,320     $  10,741
Services                                          5,549           6,059         16,758        18,044
Total cost of revenues                       $    9,499       $   9,761     $   29,078     $  28,785
Change from prior year period                        (3 )%            0 %            1 %          12 %
Product costs as a % of product revenues             25 %            25 %           27 %          24 %
Services costs as a % of services revenues           32 %            39 %           33 %          40 %

Costs of product consist of hardware costs (including media servers and Interaction Gateway appliances that we develop and 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 software packaging costs (including product media and documentation duplication). Costs 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. Costs of product increased by $248,000 and $1.6 million, respectively, during the three and nine months ended September 30, 2009 compared to the same periods in 2008, as more customers included our hardware offerings in their implementations of our solutions.

Costs of services consist primarily of compensation expenses for technical support, professional services and educational personnel and costs associated with our CaaS offering. These expenses decreased primarily due to reduced compensation expense of $301,000 and $992,000, respectively, during the three and nine months ended September 30, 2009 compared to the same periods in 2008 as a result of a 7% reduction in services staff. In addition, travel related expenses decreased by $233,000 and $701,000, respectively, as a result of the reductions in services staff. Partially offsetting these decreases were increases of $236,000 and $389,000, respectively, in CaaS expenses primarily related to data center and associated hosting costs. We believe CaaS expenses will continue to increase as our CaaS business grows.

                                          Three Months Ended          Nine Months Ended
Gross Profit                                 September 30,              September 30,
                                           2009          2008         2009          2008
                                                         ($ in thousands)
Gross profit                            $   23,671     $ 20,295     $  66,463     $ 61,364
Change from prior year period                   17 %          4 %           8 %         12 %
Percentage of total revenues                    71 %         68 %          70 %         68 %
Product costs as a % of gross profit            17 %         18 %          19 %         18 %
Services costs as a % of gross profit           23 %         30 %          25 %         29 %

Gross profit increased during the three and nine months ended September 30, 2009 compared to the same periods in 2008 primarily due to an increase in total services revenues and a decrease in cost of services revenues.

Gross profit as a percentage of total revenues in any particular quarter is dependent upon product and services revenues recognized versus costs of product and costs of services incurred.

Operating Expenses
                                       Three Months Ended          Nine Months Ended
Sales and Marketing                       September 30,              September 30,
                                        2009          2008         2009          2008
                                                      ($ in thousands)
Sales and marketing expenses         $    9,696      $ 9,547     $ 28,877      $ 29,870
Change from prior year period                 2 %          3 %         (3 )%         12 %
Percentage of total revenues                 29 %         32 %         30 %          33 %
Percentage of net product revenues           84 %         87 %         88 %          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 $149,000 during the three months ended September 30, 2009 compared to the same quarter last year due to increases in commissions and incentives resulting from the increased revenues during the quarter. Stock-based compensation expense also increased compared to the third quarter of 2008 in part due to a reduction in the forfeiture rate assumption that we used in calculating the expense during the third quarter of 2009 based on recent history and in part due to the reversal of some performance-based stock options in the third quarter of 2008, which reduced the expense in 2008. Partially offsetting these increases were decreases in reimbursements to our partners for their marketing efforts and fees paid to third parties for customer referrals.

During the nine months ended September 30, 2009 compared to the nine months ended September 30, 2008, sales and marketing expenses decreased by $993,000 due to reduced travel expenses of $662,000, reduced corporate marketing costs of $322,000 and a decrease in outsourced services of $241,000. Referral fees also decreased by $227,000 because fewer payments were made to third parties for customer referrals. Partially offsetting these decreases was an increase in compensation expense of $498,000 due primarily to increased incentives resulting from the increased revenues during 2009. We expect marketing costs to increase in future quarters.

                                      Three Months Ended          Nine Months Ended
. . .