In the past week I have had discussions with three of my clients about this question. The second is a 10 year old networking related company whose sales have started to increase dramatically. The third is a one year interactive online marketing startup with two very experienced people who are in discussions with a major record company. Remember that the Investor can earn a nice safe return by investing in U.S. Treasury bills. Ultimately valuation is a matter of negotiation.
Successful negotiation requires homework to support a convincing case.
Financial projections should be based on hard facts if possible and should be internally consistent and integrated with the business plan strategy. Multiply these numbers to get an assumed value in year 5 and then discount that number back today. The discount rate is a judgment call based on a number of variables including risk and the current market for similar investments. The result of the analysis is what the value of the company is today. Obviously the analysis involves a number of judgment calls but if you do a sensitivity analysis by varying the assumptions you would be surprised to see the number of times when you can't get anywhere near the valuation an entrepreneur is asking.