I've been teaching very young kids for a long time now. My youngest ever was 3 years old believe it or not and I still teach her now at 6 years old. It probably helps that I'm now a grandad! so I have a lot of experience keeping kids entertained.
Teaching the very young does require you to change your method quite drastically. If you're lucky you'll have their full attention for 10 minutes of a 30 minute session, but they do learn in that time.
My tips would be to make things fun, don't try and force anything, allow them to explore the guitar, even let them lay it flat on their knee if need be. Create some simple games using there toys.
Three good things spring to mind:
1) Teach them nursery rhymes (even up to the age of 7). Many of these are just 2 or 3 chords.
2) Reward them (get yourself a sticker book)
3) Let them play 1 chord in a song and you play the other. i.e. You play D, they play Em.
I could go on, but use your imagination and there are endless ways to make the lessons fun but educational.