The Volume Trap: Why Diagnostic Royalties Don't Compound

Royalty financing has become a cornerstone of life sciences capital formation, with biopharma royalty deals totaling $29.4 billion from 2020-2024. Yet the molecular diagnostics industry—now generating over $20 billion annually—remains almost entirely absent from this market. While Royalty Pharma deployed $2.8 billion into therapeutic assets in 2024 alone, pure diagnostic royalty transactions can be counted on one hand.

This divergence reflects fundamental economic differences between asset classes. Pharmaceutical royalties compound under patent protection and pricing power. Diagnostic royalties are caught in a volume trap, where reimbursement cuts systematically erode the revenue base against which royalties are calculated. Understanding these dynamics is essential for anyone evaluating diagnostic company capital structures, licensing economics, or investment opportunities.

Therapeutic vs Diagnostic Economics: Monopoly vs Volume

The core distinction lies in pricing power. Therapeutic drugs enjoy patent exclusivity that enables sustained or rising prices. Research published in JAMA found U.S. prices of patent-protected drugs increased by an average of 119% between 2011 and 2020. A royalty investor capturing 5-15% of those sales benefits from compounding growth as both volume and price rise.

Diagnostics operate on fundamentally different economics. Tests lack the monopoly pricing power that patents confer on drugs. While diagnostic companies hold intellectual property, they cannot enforce exclusivity on testing for medical conditions—alternative tests, lab-developed tests, and competitive platforms inevitably emerge. Revenue growth depends on scaling test volume, but volume growth triggers the trap: payers respond by cutting per-test reimbursement.

Factor	Therapeutics	Diagnostics
Gross margin	70-85%	30-60%
Pricing trend	+4-5% annually	Declining (PAMA cuts)
Patent protection	10-15 years	Often none
Revenue concentration	Single blockbuster products	Thousands of tests
Typical royalty rate	10-20%	1-5% (rare)
Annual royalty deal flow	~$6 billion	<$300 million

The margin differential alone explains much of the divergence. When pharmaceutical companies pay 10% royalties, they draw from gross margins exceeding 75%—the royalty consumes roughly 13% of gross profit. For diagnostic companies operating at 40% gross margins, that same 10% royalty would consume 25% of gross profit, potentially eliminating operating margin entirely.

The PAMA Trap: Systematic Price Erosion

The Protecting Access to Medicare Act (PAMA) transformed diagnostic economics by establishing market-based pricing using weighted median private payer rates. Implementation from 2018-2020 cut approximately $3.8 billion across 800 tests before Congressional delays froze additional cuts.

The mechanism creates structural headwinds for royalty financing. CMS collects private payer rate data from "applicable laboratories," calculates the weighted median, and establishes this as the new Medicare rate. The critical flaw: less than 1% of laboratories submitted data in the first reporting cycle, with independent labs (negotiating lower commercial rates) representing 90% of reported data while hospital outreach labs (with higher rates) submitted only 1%.

PAMA Period	Annual Cut Cap	Status
2018-2020	10%/year	Implemented (~$3.8B impact)
2021-2024	0%	Congressional moratorium
2025	0%	RESULTS Act extension
2026-2028	Up to 15%/year	Scheduled absent reform

Specific tests face substantial erosion when PAMA fully resumes. The American Clinical Laboratory Association projects 2026 cuts including: hemoglobin A1C (12%), comprehensive metabolic panel CPT 80053 (14%), heart disease tests (15% collective), hepatitis B/C and HIV tests (11-15%), and hereditary cancer tests (11-15%).

For a diagnostic company locked into royalty payments on test revenue, government-mandated price cuts increase the royalty burden proportionally as revenue shrinks—potentially converting profitable tests into loss leaders overnight.

The NPV Showdown: 15% Therapeutic vs 5% Diagnostic

Consider a simplified comparison between two royalty opportunities from an investor perspective.

Therapeutic royalty deal: Invest in a marketed drug and receive 15% of net sales for 10 years. Patent exclusivity and growing demand. Sales ramp to peak, then decline gradually as patent expiry approaches.

Diagnostic royalty deal: Invest in a diagnostic test and receive 5% of net sales for 10 years. Strong initial reimbursement, but typical market dynamics: competing tests emerge, and payers ratchet down prices 5-10% annually under PAMA.

Year	Drug Sales ($M)	Drug Royalty ($M)	Dx Sales ($M)	Dx Royalty ($M)
1	50	7.5	30	1.5
2	100	15.0	55	2.8
3	175	26.3	80	4.0
4	225	33.8	105	5.3
5	260	39.0	125	6.3
6	270	40.5	135	6.8
7	265	39.8	140	7.0
8	250	37.5	142	7.1
9	220	33.0	143	7.2
10	180	27.0	145	7.3
NPV (10%)		~$165M		~$28M

The drug's sales grow and peak under patent protection, while the diagnostic's revenue plateaus as reimbursement cuts offset volume gains. At a 10% discount rate, the therapeutic royalty NPV exceeds the diagnostic by approximately 6x—reflecting both the higher royalty rate and stronger underlying growth profile.

This disparity explains why royalty financiers approach diagnostics with extreme caution. The deals can easily become "dead money" where royalty streams never accelerate enough to beat cost of capital.

ADLT Designation: Temporary Protection, Guaranteed Erosion

The Advanced Diagnostic Laboratory Test (ADLT) pathway provides temporary pricing protection for innovative tests meeting specific criteria: Medicare Part B coverage, single laboratory exclusivity, no sales to other labs, and either multi-biomarker analysis with unique algorithms or FDA clearance.

ADLT tests receive three calendar quarters at actual list charge before transitioning to weighted median pricing. This creates a predictable erosion trajectory that royalty investors must model.

Test	Code	Laboratory	Initial Rate
Guardant Shield	0537U	Guardant Health	$1,495
Tempus xT CDx	0473U	Tempus AI	$4,500
Signatera (MRD)	0340U	Natera	$3,500
Guardant360 CDx	0242U	Guardant Health	$5,000
FoundationOne CDx	0037U	Foundation Medicine	$3,500
DecisionDx-Melanoma	81529	Castle Biosciences	$7,193
Cologuard Plus	0464U	Exact Sciences	$591.92

Post-initial period, ADLT tests face annual data reporting requirements and transition to weighted median pricing. The protection delays erosion—it doesn't prevent it.

The Rare Diagnostic Royalty Deals That Actually Closed

Only two significant diagnostic-adjacent royalty transactions closed in 2023-2025, and both illuminate why such deals remain exceptional.

BillionToOne / Oberland Capital (September 2024)

BillionToOne secured $140 million from Oberland Capital structured as multi-tranche non-dilutive financing. The initial $50 million draw repaid existing $35 million term debt, with up to $90 million available for future growth. Notably, the deal was characterized as "notes" rather than traditional royalty participation—specific royalty rates were not disclosed.

The company subsequently completed a November 2024 IPO at $60 per share, raising approximately $273 million. The structure appears to function more like secured debt with revenue-linked features than perpetual royalty encumbrance.

Heidelberg Pharma / HealthCare Royalty (March 2024)

Heidelberg Pharma's deal with HCRx covers TLX250-CDx (Zircaix), a PET imaging diagnostic agent for renal cancer—technically diagnostic though distinct from traditional IVD/molecular testing.

Tranche	Amount	Trigger
Upfront	$25M	Signing
Second	$70M	FDA approval
Third	$15M	2025 sales milestone (eliminated in amendment)
Total	$115M+

Critically, cumulative royalties are capped at maximum value, with only a "low single-digit royalty percentage" continuing after cap achievement. A March 2025 amendment reduced second tranche to $70M and eliminated the sales milestone—reflecting the challenging economics even for this diagnostic-adjacent asset.

How Diagnostic Companies Actually Finance Themselves

Major diagnostic companies have converged on convertible debt as their primary financing mechanism, avoiding royalty structures entirely. The economics are compelling: 0-2.25% interest rates versus 15-20%+ effective royalty costs.

Exact Sciences

Exact Sciences maintains approximately $2.325 billion in convertible debt across multiple series:

Series	Coupon	Principal	Maturity	Conversion Premium
2027 Notes	0.375%	$466M	2027	~27.5%
2028 Notes	0.375%	$440M	2028	~27.5%
2030 Notes	2.0%	$500M	2030	Exchange
2031 Notes	1.75%	$620.7M	2031	35%

The company also secured a $500 million senior secured revolving credit facility with JPMorgan Chase in January 2025. Notably, Exact Sciences has worked to eliminate royalty obligations—in 2017, the company paid $8 million to buy out a low-single-digit royalty under its MDx Health license.

Guardant Health

Guardant Health raised $717 million in May 2025 through concurrent common stock ($327 million net) and zero-coupon convertible notes due 2033 ($390 million net). The zero-coupon structure provides interest-free financing for eight years—terms impossible under royalty arrangements.

In February 2025, Guardant exchanged $659.3M of 0% notes due 2027 for $600M of 1.25% notes due 2031, extending maturity by four years while reducing principal by $59.3M.

Natera

Natera provides the clearest deleveraging case study. After taking $100 million in senior secured debt from OrbiMed in August 2017 (LIBOR + 8.75%), the company refinanced into $287.5 million of 2.25% convertible notes due 2027 in April 2020. By October 2024, Natera fully redeemed all convertible notes at par, leaving only an $80.4 million UBS credit line.

Tempus AI

Tempus AI emerged from its June 2024 IPO with significant Ares Capital debt exposure (~$560M total facilities). In July 2025, Tempus issued $750 million in 0.75% convertible notes due 2030, using proceeds to repay $274.7M in term loans and fund capped call transactions.

Myriad Genetics

Myriad Genetics secured a $200 million term loan from OrbiMed in July 2025—notably structured as traditional secured debt rather than royalty participation.

Term	Detail
Principal	$200M ($125M at close, $75M delayed draw)
Rate	SOFR + 6.50% (2.50% floor)
Maturity	July 2030
Security	Substantially all assets
Revenue covenant	$615M-$974M trailing 12-month minimum

Why Convertible Debt Beats Royalties for Diagnostics

The structural advantages of convertible debt for diagnostic companies are substantial:

Factor	Convertible Debt	Royalty Financing
Interest/payment rate	0-2.25%	5-15%+ effective
Duration	5-7 years (finite)	Often perpetual
Operating covenants	Minimal	Revenue-based restrictions
Reimbursement risk	Not linked to per-test pricing	Directly exposed
Upside preservation	Conversion premium protects equity	Royalty compounds with success
Cash burden during losses	Interest only	Payments from revenue

The diagnostic business model—recurring test-by-test reimbursement rather than concentrated product sales—simply doesn't fit synthetic royalty structures designed for blockbuster therapeutics. Tracking royalties across thousands of tests with variable volumes, multiple payer rates, and bundled ordering creates administrative complexity that doesn't exist in pharma.

Existing Diagnostic Royalty Obligations

Despite avoiding royalty financing structures, diagnostic companies do pay licensing royalties for underlying technology—typically at rates far below pharmaceutical norms.

Exact Sciences / Mayo Clinic

The Cologuard agreement with Mayo Clinic, signed June 2009 and amended through 2017, established the model:

Component	Terms
Royalty rate	"Low single-digit" (1-4%) on net sales
Minimum annual royalty	$25,000
Upfront payment	$80,000
Clinical trial milestone	$250,000
FDA approval milestone	$500,000
Amendment payments	$5M through 2019

The agreement covers all gastrointestinal cancers and, as of 2016, all cancer types including lung and pan-cancer screening.

Guardant Health

Guardant sits on both sides of royalty arrangements. The company receives ongoing royalties from Foundation Medicine under a January 2022 settlement ($25 million upfront plus royalties). However, a November 2024 jury verdict awarded TwinStrand/University of Washington $83.4 million in royalty damages at a 6% rate—a decision under appeal.

GRAIL / Illumina

GRAIL owes Illumina a "high single-digit royalty, subject to certain reductions, in perpetuity" on revenues regardless of whether products incorporate Illumina intellectual property. Following GRAIL's June 2024 spinoff (ordered by EU regulators), this perpetual royalty obligation resumed after being suspended during the ownership period.

University Technology Transfer Benchmarks

Analysis of major research universities found average royalty rates of 3.5-4.6% with a median around 3% for diagnostic technologies. Stanford University's diagnostic licensing terms specify 3% during exclusive periods, dropping to 1.5% during non-exclusive periods.

Licensor Type	Typical Diagnostic Royalty
Academic institution	2-5%
Corporate license	5-8%
Pharma therapeutic	8-18%

International Dynamics: No Hedge Against US Pressure

Cross-border analysis reveals that US diagnostic reimbursement—despite PAMA pressures—remains the highest globally, making international expansion an imperfect hedge.

European Markets

Germany's EBM system updates quarterly using point-values multiplied by base rates. A 2022 Swiss comparison study found common laboratory tests cost approximately three times more in Switzerland than in Germany, France, Austria, or the Netherlands.

France reduced its NABM B-coefficient from €0.27 to €0.26 in February 2023, saving €45 million. The 2023 Social Security Financing Act targeted €250 million in lab test savings.

EU IVDR compliance costs have transformed the market. Under the prior IVDD regime, approximately 80% of IVDs were self-certified; under IVDR (effective May 2022), 80-90% now require Notified Body involvement.

Asia-Pacific

Japan's biennial revision system applies 5-10% average reductions. The Foreign Average Price rule automatically adjusts Japanese prices downward if they exceed 1.3x the average of US, UK, Australia, France, and Germany.

China's Volume-Based Procurement represents the most aggressive pricing mechanism globally:

Category	Price Reduction
Coronary stents	95%
Knee replacement	84%
Regional IVD tenders	~60% average

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The ASP Floor: Essential But Insufficient Protection

One contractual safeguard essential in diagnostic royalty deals is the Average Selling Price (ASP) Floor—a minimum price per test used to calculate royalty payments regardless of how low actual reimbursement falls.

For example, if a test initially reimburses at $500 and an ASP floor is set at $400, royalty payments would still calculate as if each test brought in $400 even if insurers cut the price to $300.

However, ASP floors have limitations:

• If volume growth doesn't vastly outpace price declines, the floor merely delays pain
• Floors typically set at modest discounts (15-25%) from initial reimbursement
• Sellers effectively subsidize the difference when market price falls below floor
• Renegotiation provisions may allow adjustments if conditions change drastically

The Revolution Medicines / Royalty Pharma deal ($2 billion, June 2025) demonstrates evolved protection mechanisms for therapeutics: tiered royalty rates that increase if annual net sales fall below thresholds. This approach could theoretically apply to diagnostics but would require significant structural adaptation for reimbursement-driven pricing.

The Invitae Cautionary Tale

Invitae's February 2024 bankruptcy illustrates what happens when diagnostic companies over-leverage—even without royalty obligations.

The company accumulated approximately $1.5 billion in debt through aggressive acquisition-funded growth:

Financing	Amount	Terms
SoftBank convertible notes	$1.15B	1.5% interest, $43.18 conversion
Perceptive senior secured	$200M	LIBOR + 875bp
Oxford Finance	$40M	Senior secured

The ArcherDX acquisition in October 2020 ($1.4 billion deal value) exemplified the problem: financing through PIPEs and debt for an asset that never achieved projected synergies.

Labcorp acquired substantially all assets for $239 million in August 2024—a 15-cent recovery on liabilities. The timeline from $1.5 billion in funding to bankruptcy took less than three years.

Diagnostic Financial Metrics vs Pharma

The margin differential that makes royalty financing challenging shows clearly in reported financials:

Company	2024 Revenue	Gross Margin	Operating Income
Exact Sciences	$2.78B	69%	($147M)
Natera	$1.7B	60.3%	($98M)
Guardant Health	$735M	62%	($285M)
Veracyte	$456M	66.9%	$24.1M profit
Myriad Genetics	$838M	71.7%	($69M)

Compare to large pharma gross margins of 76-83% with operating margins of 25-35%. The diagnostic margin structure leaves minimal room for royalty extraction without threatening viability.

Legislative Reform: The RESULTS Act

The RESULTS Act (September 2025) attempts to address PAMA's structural problems:

Provision	Current Law	RESULTS Act
Rate freeze	Through 2025	Extended through 2028
Annual cut cap	15%	5%
Reporting cycle	3 years	4 years
Data collection	Lab self-reporting	Independent commercial claims

Industry lobbying spending increased from $2.5 million (2017) to $4.4 million (2018), with ACLA's "Stop Lab Cuts" campaigns leading advocacy efforts.

If enacted, the RESULTS Act would reduce reimbursement volatility that makes diagnostic royalty financing particularly risky—though it wouldn't eliminate the fundamental margin compression challenge.

Conclusion: Structural Barriers Will Persist

The diagnostic royalty market's underdevelopment reflects rational investor behavior given current reimbursement frameworks. PAMA creates systematic downward price pressure absent from pharmaceutical markets. ADLT designation offers temporary protection but guarantees eventual price erosion. International markets provide no hedge—most feature lower absolute prices with similar cost-containment mechanisms.

For royalty financing to work in diagnostics, deals require significant structural modifications:

• Caps on total payments limiting investor upside but protecting company economics
• Low single-digit base rates (1-4%) reflecting margin realities
• Milestone-heavy structures front-loading returns before reimbursement erosion
• ASP floors with clear renegotiation provisions
• Shorter durations (5-7 years vs perpetual) matching technology cycles

The Heidelberg/HCRx structure—with capped cumulative payments and tail royalty reduction—provides a template. But for most diagnostic companies, convertible debt at 0-2.25% will continue to beat perpetual royalty encumbrance at rates that would compress already-thin margins to unsustainability.

The fundamental insight: diagnostic royalties don't compound because the underlying economics don't compound. Volume growth is offset by price erosion. Margin structure limits extractable value. Technology cycles truncate revenue duration. Until these fundamentals change, royalty financing will remain a pharmaceutical phenomenon.

Disclaimer: I am not a lawyer or financial adviser. This article does not constitute investment advice, legal advice, or financial advice of any kind. All information presented here is derived from publicly available sources including SEC filings, press releases, and industry reports. Details of specific transactions may have changed since publication. Readers should conduct their own due diligence and consult with qualified legal and financial professionals before making any investment or business decisions.